If active managers arent feeling loved these days, they might want to reach out to insurance companies and corporate pensions plans, which have less use for index funds.
Its frustrating to hear somebody say, We should be all active or all passive, said Woody Bradford, chairman and chief executive officer of Conning, an investment manager that focuses on insurance companies and pension funds. Thats a hammer calling every client a nail.
Insurance companies, which are highly regulated, customize their holdings based on liabilities, liquidity, cash flow and capital adequacy requirements. They build portfolios that pull from a variety of active and passive strategies, a strategy that Bradford says should also apply to corporate pension funds, which increasingly look a lot like insurers.
The notion of passive being broadly applied to solve insurance companies problems shows a real lack of understanding of what investing is like for these clients, he said.
Since the 2008 financial crisis, investors have continued to withdraw money from active managers in every equity category in favor of low-cost passive funds. The trend is fueling cynicism about the future of managers that rely on fundamental research.
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Insurers have traditionally positioned the majority of their investment portfolios in fixed-income. Last year, bonds represented 83 percent of the U.S. life insurance industrys $3.1 trillion of investable assets, according to Conning. Active managers in fixed income often beat rival index funds because they have the ability to avoid credit downgrades of securities.
The percentage of downgraded securities in the Bloomberg Barclays Investment Grade Index, a popular benchmark for bond index funds, was 2.8 percent on an annualized basis from the beginning of 2001 through June. For the same period, Conning saw 0.9 percent of its investment-grade credit holdings downgraded, or 1.9 percentage points less than the index.
Insurance companies are increasingly embracing fixed-income exchange-traded funds that are passively managed, says Bradford. Theyre using the ETFs for niche investment opportunities such as emerging markets and to quickly gain exposure to areas like high-yield debt. Theyre also using bond ETFs, which can be easily sold in stressed markets, as a higher-yielding alternative to holding cash.
According to Connings own research, one in three insurance companies are using ETFs and 81 percent of insurers have increased their use of the funds over the last three years.
While popular, Bradford says insurers have to keep their embrace of ETFs on the margin because the off-the-shelf products cant be used precisely enough to effectively manage their liabilities. They also arent flexible enough for insurers to use them to manage their taxes and other investment goals.
Without active management to match assets with future liabilities, investment strategies could, over time, become very misaligned from an insurance companys liability streams, said Bradford.