FUND BOUTIQUES & PRIVATE LABEL FUNDS: Financial centre Switzerland – “Big is ugly” & CAT Bonds – Investment capacity & optimal fund size as a critical success factor for asset managers (Interview – Dirk Schmelzer, Plenum Investments AG)

Switzerland is often considered the center of competence in the CAT bond segment. “Big is ugly” – Markus Hill spoke for FUNDBOUTIQUES.COM with Dirk Schmelzer, Plenum Investments AG, about strategic success factors for asset managers in this “niche market”. The market share of natural catastrophe risks in the CAT bond market is approximately USD 33 billion or 68% measured against the total market (USD 48 billion). The CAT bond fund market (UCITS) holds USD 8 billion worth of CAT bonds, with the three largest funds accounting for USD 6 billion. The question arises as to the optimal or maximum fund size.

Hill: In your opinion, is the CAT bond fund market optimally diversified?

Schmelzer: Although the CAT bond market offers a high degree of diversification due to a large number of independent risks available, the strong focus on U.S. risks, which in turn are characterized by concentration in a few regions, creates a highly lopsided risk profile that exposes investors to U.S. hurricane risks in particular. While diversification away from hurricane risks has limited feasibility due to the scarcity of diversifying risks in this market, risk diversification within the U.S. hurricane segment is very much possible and indeed warranted.

Hill: To what extent does a fund’s risk-return positioning drive its maximum investment capacity?

Schmelzer: Basically, CAT bond investments can be used to implement a very wide range of different risk/return profiles. However, very conservative but also very dynamically oriented risk/return targets inevitably lead to a limitation of the investable universe. If the focus is also on avoiding risk concentrations and the associated reduction of potential losses in the event of extreme events (tail risk reduction), the investment universe is further reduced, as CAT bonds with a high degree of overlapping risks must be excluded or at least allocated at a greatly reduced level. Such selective investing CAT bond strategies can only be implemented with a limitation of the investment volume.

Dirk Schmelzer, Plenum Investments AG
Dirk Schmelzer, Plenum Investments AG

Hill: How big is the risk of dilution if you exceed the optimal fund size?

Schmelzer: On the performance side, the risk of dilution is relatively small; we consider the implications on risk management to be more serious. There is a risk that CAT bonds with a high correlation to existing positions have to be bought to be fully invested. This leads to undesirable concentrations of risk in the portfolio.

Hill: What investment capacity do you see in mutual funds that replicate the market?

Schmelzer: Here, the question arises primarily in terms of the liquidity offered to investors in such vehicles. Ultimately, the composition of the fund’s investor base is also an important factor. Hence the question cannot be answered in general terms, but in our view, such funds should not exceed an investment volume of around 5% of the outstanding CAT bond market. In other words, the current critical fund size is about $1.5 billion.

Hill: How does fund size affect diversification behavior?

Schmelzer: The larger a fund, the greater the pressure to invest in all outstanding CAT Bonds to maintain a high investment ratio. This makes it hard to avoid high-risk correlations in this market that is heavily focused on U.S. risks, which increases the risk of significant losses, should a natural catastrophe occur in the U.S.

Hill: Isn’t the broker in a better position knowing that huge funds are forced to invest into the new issuances because they have to redeploy about a third of their assets under management during renewals?

Schmelzer: I think we are talking about mutual dependencies here. The fund manager is indeed dependent on receiving corresponding allocations to cover his investment needs. But the broker is also dependent on being able to place his new issues, and large investors play a vital role in this. The placement pressure for huge funds is, therefore, more pronounced than for smaller funds.

Hill: What optimizations are in the offing if you are targeting market-like returns?

Schmelzer: Since the natural catastrophe market is not efficiently diversified per se, the question is how to realize efficiency gains. This question is reflected in our “quality concept”, in which we focus on per-event covers (per occurrence), i.e. avoiding so-called “all-natural perils” covers on a loss-aggregating basis and where we aim for high regional and global diversification with little overlap of peril region exposures across the holdings in the fund. We thereby underweight low-return bonds with low diversification benefits that, should a very large catastrophe occur, will be triggered as well as higher-return investment alternatives. This allows us to raise the average expected loss and thus the absolute risk compensation without increasing the risk of large losses in the fund (tail risk). To achieve this goal, we rely on strict selection and a restriction to a small number of individual positions that are less correlated with each other. As these individual positions are closer to the risk, their sensitivity to smaller insurance losses increases. This applies in particular to transactions that aggregate losses and are exposed to so-called secondary risks. We, therefore, place a strong focus on per-event covers in the selection process and substantially reduce loss-aggregating structures for secondary perils. In short, we should get a similar tail risk behavior as the index with increased returns.

Hill: What impact does the “quality concept” have on optimal fund size?

Schmelzer: Maintaining the quality of funds targeting market-like returns imposes a significant constraint on investment capacity to take advantage of the limited supply of suitable positions in the CAT bond market. A constrained capacity is thus not a means to reach this goal, but merely the logical consequence. After all, if you invest in a niche asset – to which CAT bonds belong – you should be limiting the “capacity” of a CAT bond fund, unless you want to build a market portfolio, which in our view is not efficient. The capacity issue is further exacerbated if one does not have the entire investment universe at one’s disposal due to the investment objectives. To cut a long story short: From today’s perspective, we see a maximum investment capacity of 400 million US dollars for the “Quality Concept”. In a nutshell: Big is ugly – investment capacity in the CAT bond fund segment is a critical success factor!

Hill: Thank you very much for the interview.

Dirk Schmelzer joined Plenum Investments in 2010 as senior portfolio manager for insurance-linked securities (ILS). From 2005 to 2010, he was responsible head of ILS at Falcon Private Bank (formerly AIG Private Bank), Zurich, and responsible portfolio manager for ILS fund products and asset management mandates. Previously, he was deputy head of fund research at VZ VermögensZentrum. Mr. Schmelzer holds a degree in industrial engineering from the Technical University of Braunschweig and holds the titles of Chartered Alternative Investment Analyst (CAIA) and Hedgefunds-Advisor (EBS/BAI).

Plenum Investments


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