Guest Q&A with Randy Brown
IAUM: You mentioned during our lunch that the capital markets’ “plumbing is broken”. What does that mean and why does it concern you?
BROWN: I feel that there are imbalances and gating mechanisms in the markets today that could introduce significant volatility in a period of changing investor perceptions. The size of the corporate bond markets, including high grade, high yield, and syndicated loans, has grown significantly post the Great Recession. At the same time, the amount of balance sheet devoted to inventory and market-making has fallen dramatically due mostly to regulatory changes. I believe that this will lead to bigger bouts of price discontinuity than we are used to seeing in the bond market. Ultimately, some of this risk will need to change hands through a very small gate-keeping mechanism! Additionally, risk is held in forms with a greater degree of perceived liquidity, such as mutual funds and ETFs, where there is often greater herd mentality and a lack of differentiation between liquidity and price continuity. I Fear this could introduce some regulatory noise to the markets after the next recession as politicians and regulators respond to negative publicity in the press.
IAUM: An increasing number of insurers are using ETFs. What’s your view of ETFs for insurance companies? Any specific concerns?
BROWN: I believe that ETFs are a tool that can be used by insurers as a means to express tactical calls in the general account more quickly. As discussed above, executing in the cash market has gotten more challenging, so large investment moves can be executed more quickly via the ETF and then expressed in the cash market over time and unwound in the ETF market. I do not believe that they are a substitute for the majority of the cash bonds in a general account, where we are very specific in the limits we put on names, which we choose, and the recognition of gains and losses. Also, the fees in an actively managed fixed income account are quite competitive, especially given the very customized nature of that management. Pure market weighted indexed holdings falsely reward those companies that are the largest issuers, the very names that we want to hold more prudently.
As to concerns, I think that ETFs to date have behaved relatively as expected, with exchanges matching buyers and sellers – so transferring risk efficiently. I do worry a bit that there is a misunderstanding of what liquidity means. Additionally, unless we can get some regulators to change their views, some ETFs are inefficient with respect to capital treatment. There is quite a bit of industry effort underway to educate and hopefully persuade them to change this treatment.
IAUM: We talked about the fact that risk premia has been driven down because there is a lot of capital chasing a wide spectrum of asset classes. Is there anything that is cheap out there?
BROWN: I don’t think there are many cheap sectors anymore, but on a relative basis we still like the Private Debt market. Here I refer to investment grade private loans rather than the middle market space that I see as very overcrowded. We can achieve a reasonable illiquidity premium and pick up covenant protection that will serve us well in a downturn. We have and will continue to experience not only lower defaults, but also lower losses given defaults in the private space given our ability to modify the terms if a company hits a speed bump.
This is the point in the cycle to maintain a quality standard and not chase yesterday’s higher yields! Short spread product that will roll off and allow you to reinvest into what I believe will be higher yields and wider spreads is also a safe harbor. High quality corporates, while historically expensive, should be ‘money good’ at the front of the curve and allow a modest increase in total return vs Treasuries.
IAUM: Risk management is a big part of any CIO’s job. What is the biggest risk management challenge that you face today?
BROWN: The biggest challenge I face is balancing the need as a public company for quarterly earnings with the desire to reduce risk given the current spread and risk environment. As I mentioned, spreads are pretty tight by most measures, but there are many risks in the markets. Central banks are generally raising rates and reducing balance sheets, corporations are continuing to do shareholder friendly things such as dividend increases and buybacks, and there are many geopolitical risks in the market that could significantly alter risk appetites. We also have a new dynamic, which is the volatility introduced by erratic rhetoric coming from the US President and the uncertainty it introduces. Markets have largely ignored all of these tail events.
IAUM: Many asset managers think the insurance GA market offers a big opportunity. You’ve been on that side of the business, do you agree?
BROWN: I do agree! The delivery of consistent, risk managed, returns is getting increasingly harder to do. Specialist Insurance focused managers have the expertise to do this, and do it at a very competitive price that offers tremendous value. The need to add additional asset classes where an internal team may not have the expertise also introduces a source of demand for external managers. We have seen tremendous growth in outsourcing in areas such as private debt, commercial real estate debt and equity, bank loans, high yield, CLOs, and structured finance. This is quite logical to me and a trend that I do not see changing.
Managing assets for insurers is fundamentally different than managing other pools of capital, so hiring a manager with this specific focus is important. We focus first and foremost on return of vs on principal. We manage in a very risk aware way, and balance the needs for return with the realities of capital, accounting, tax, and regulatory considerations on the investment portfolio as we manage through market dynamics. This requires a different mindset than a typical manager whose sole focus is on beating a benchmark.
IAUM: What will be the most difficult challenge facing CIOs in 2019?
BROWN: I don’t think (hope??) that 2019 will be a difficult year for the markets, but we could see challenges in the years after in the credit markets. Thus, 2019 will be about avoiding the pressure to chase spreads and returns, balancing the needs of the liability side of the balance sheet with prudent risk management and mitigation.