Stewart: Welcome to another edition of the Insurance AUM Journal podcast. My name is Stewart Foley, and I’ll be your host standing with you with the corner of insurance and asset management with Craig Stapleton, CIO of Investment Strategies and Risk at Securian Financial Group. Welcome, Craig.
Craig: Thank you for having me, Stewart.
Stewart: It’s great to have you on. It is a really interesting capability that you’re going to talk about, is really interesting and new to me in your role at Securian that your title says investment strategies and risk. What does that entail?
Craig: Stewart, I’ve taken a long journey in my career. I started off really to help build the risk management in the hedging of variable annuity guarantees for the insurance company more than 15 years ago and since then we expanded our hedging capabilities but then in 2008 took over asset allocation for the broader general account of the insurance company. 2010 became a general account portfolio manager, 2011, 12 helped develop strategies that benefited the insurance company. One of them is what we’re going to talk about today, and it is really devoted towards managing risk in an equity portfolio for our variable annuities specifically for the guarantees that we provide to policy holders. But more broadly I think it’s an asset class that’s new to investors across the spectrum and I think it’s an interesting new way of approaching risk.
Stewart: But when you started this capability it was done at your parent first, right? At Securian, is that how it came to be developed originally?
Craig: Yeah. Coming out of the GFC, the great financial crisis, a lot of insurance companies took a step back, us included. Those who provided variable annuities with these very deep embedded put options or written puts on top of these variable annuity chassis, they took a capital hit in 2008 with the 55% decline in the S&P 500. So what do you do when the capital drain occurs when you don’t want it to occur? And you saw in the news Hartford took it on the chin, still alive but barely breathing. And a lot of us decided on a different approach do we mitigate how many assets go into the equity classes because it’s more expensive to put options on those or do we manage the equity assets differently?
Craig: And we chose the route of manage the assets differently. We brought in a consultant, the consultant said managed volatility was a way to go. I was very skeptical as some of the listeners probably today that you can provide protection without destroying returns. I did a lot of research back in 2010, 11, 12, and I was pleasantly surprised that there are some paradigms in the marketplace where you can take advantage of these different asset classes and the way they respond to different volatility environments and the way the returns correspond to those different volatility environments.
Craig: We created a managed volatility portfolio. We call it equity stabilization now because a lot of these managed volatility portfolios that insurance companies developed had tremendously horrific returns, whereas we’ve had very strong returns and a very dramatic reduction in risk or drawdown protection. I think it’s a very exciting thing not just for insurance companies but across the spectrum of institutional investors.
Stewart: And it’s interesting, you talked about sometimes the risk of management strategies don’t live up to their billing when you’ve got market duress, downturns and changes in correlation. Can you talk a little bit about the double-edged sword that investors face when they think about risk assets in their portfolio?
Craig: Yeah. This is a very exciting topic to me, maybe not to everybody, but traditional asset allocation has always been to put more money into fixed income to reduce risk. You think about a balanced fond, a 60/40 allocation, 60% to stock, 40% of fixed income. In this last drawdown event with the COVID-19 occurrence in March and April fixed income interest rates fell but credit spreads widened out more than interest rates dropped so you actually had a negative return on most corporate positions, corporate bond positions, so those strategies didn’t work out well.
Craig: And then you think about other strategies to try to manage risk in the equity portfolio. Low volatility strategy has been a hot topic the last few years, but low volatility names the high dividend-paying… Blue chip names actually underperformed versus the growth names. You think about the Microsoft, the Apple, they’ve actually done quite well in this COVID environment. And then you think about risk parity, that’s a strategy that has been at the headline of risk management for institutional investors, Bridgewater being the big name out there, and that’s not working anymore.
Craig: Why is it not working? Because interest rates are so low, there’s only so low that it can go, at least I hope so. It doesn’t make sense to have negative interest rates over prolonged periods of time, we’re at 93 basis points on the 10-year treasury. Could it go to zero? Yes. Could it go negative? Yes. But there is a floor at some point and as credit spreads widen you actually have bigger impacts coming from credit spreads and you have on declining interest rates. So all of us are incentivized to take more risk. You look at the S&P 500, the top dividend paying names of that, the 50, 75 names, you could get four and a half, 5% of dividend yield off of those equity names. So that compared to two-ish percent on a 10-year corporate bond makes a lot of sense from a long-term perspective but you are taking a lot of tail risk or big volatility risk within your portfolio.
Craig: So how do you manage that? And that’s really where we believe equity stabilization plays well. It’s something that’s new, a concept that’s new but it’s more important now than ever because interest rates and fixed income more broadly is not helping you dampen your portfolio. It might actually add risk to your portfolio if we ever go into a rising interest rate environment.
Stewart: And when we talk about equity stabilization, this is a permanent strategic allocation, right? This isn’t a tactic, if you will, the way that you think to go about it is this permanent allocation.
Craig: Yeah. This is something that we’ve talked about a lot. A lot of investors want to believe that they can catch the bottom and invest in equities at the right time or get out of equities at the top. That’s generally not the case. And especially now I’m looking at equity valuations they are quite robust, I would say overvalued. You can look at it versus 1999, it feels more like the dot com-type valuation level than not. Will it lasts for another couple of years? Maybe, but I don’t know when the next crash is going to occur, you don’t know when the next crash is going to occur.
Craig: We like to think that you want more stabilization in your equity strategies because you’re going to take more of that at risk because it does make sense over long periods of time but you don’t want to have a big negative 55% decline in your equity portfolio.
Stewart: Craig, the volatility-based equity stabilization, I believe that is rules-based. Can you explain that principle of the rules-based nature of your equity stabilization?
Craig: Yeah. This is something that I’ve found through a lot of research. It’s a little bit surprising because it goes against the idea that if you take more risk you get more return. I mean, that’s what we’ve all learned in our investment classes, in universities across America. But what you actually see within different equity markets across the world, whether it be large-cap, small-cap, mid-cap, it doesn’t matter. I’ve seen it across all different regimes, time periods, asset classes, and what you see is that low volatility actually corresponds with higher average returns and higher volatility environments correspond with lower or negative returns.
Craig: We actually have a great chart that shows that as you look at higher volatility months and look at the corresponding returns they drop pretty linearly until you get to very high volatility environments where it’s usually a big negative drop-off. The way I rationalize this is that when you get uncertainty you get economic uncertainty, you get market uncertainty as far as pricing, you get geopolitical risk, uncertainty about wars or politics. There gets to be this uncertainty where investors don’t know what to do. Good news comes out they start buying, bad news comes out they start selling, volatility increases within the broader market and then you see a big repricing of risk, which means a drawdown or a decline in equity prices until we hit a level where investors find it attractive enough to step back into the market.
Craig: This has persisted throughout all history around the world. I think it is psychology-driven and I think it will persist, I don’t see any reason that it won’t. So what this means is that in low volatility environments lean into the equity market, take a little bit more equity risk. When volatility starts to re-emerge, step a little bit away from the market. You could call it market timing but really what we’re saying is we’re going to dodge a little bit of the turbulence that occurs in higher volatility markets. And usually that means that you’re going to dodge out of some of those big drawdown events.
Craig: And we think it’s a great way of systematically getting in and out of the market in a smart way. I don’t think you want to try to market time and say, “Valuations are high, we’re going to get out.” Or, “Valuations are low, we’re going to get in.” That hasn’t worked but this volatility methodology does work. And at the very least you will see more persistent returns, a more stable path, so you as a investor, you as an insurance company don’t have to worry about getting those big, massive declines that are the most negative and brutally painful at the wrong period of time.
Stewart: We just talked about market timing and I’ve been around a long time, I know our audience knows I’m great as I could get and yet I’m still tempted with this market timing idea, right? I mean, even though I know it’s not right, I think you’re right it is a psychological phenomenon where I feel that like, “Oh, is it too much? Should I get out?” That leads me to the question which is, is there a… Here’s my air quotes “right time” in a market cycle to implement the volatility-based stabilization strategy.
Craig: When I’m joking with people I’d say right now because I’m looking at the FANG stocks, the top five. Now, Tesla’s part of that, that equation as well, a highly valued company. Valuation doesn’t make any sense to me and those investors who have been around I think probably everybody who’s listening to this recall I have been around back in the dot com bubble. Some of it just doesn’t make sense, it doesn’t feel right. We know that central banks have propped up risk assets, we know that valuations are a little bit stretched, we know that the underlying economy is not as great as what others might say it is, we know unemployment’s not great. So there’s a lot of uncertainty and we all think… I think a lot of institutional investors are saying, “Let’s get out, let’s get out.”
Craig: But at the same time if the support is there from the underlying banks around the world, maybe it’ll go another year, maybe it’ll go another two years. And that’s the pleasant surprise of this type of strategy is that it will stay in until things start getting a little dicey. It’ll take the risk out when things get a little bit more turbulent and that is a heck of a lot safer than you saying, “You know what? Valuations are stretched, I’m getting out.” And then your CEO is going to turn to you and say, “Why did we get out a year ago? The equities went up another 10%, we lost $100 million by getting out.” This takes the weight off your shoulders, this is systematic and very scientifically-proven way of managing risk in a smart way without you making subjective decisions.
Stewart: It’s interesting that you say that. The old saying goes, “Hindsight is 2020. “It’s easy to second guess in the mirror. Securian has a couple of previously established solutions in this space. Can you talk about those in terms of how they fit into or what they can accomplish in a portfolio?
Craig: Yeah. We have developed a number of strategies that we utilize internally for clients, one of them being the S&P 500 with fixed income and the S&P 500 by itself, and then low volatility stocks with an overlay risk management as well as doing a risk management overlay on top of active equities coming from a different asset manager. I think that’s the beauty of what we do. We think of it as passive or active equity underlines and then we do active hedging on top of it.
Craig: It doesn’t matter if we run the assets or not, we can do an overlay on top of existing managers, we can do an overlay on top of passive managers, or we could create a solution customized for anybody who’s looking to add a different asset class to their mix. The broad idea being that we look at the underlying equity holdings and the risk associated with them and we use futures predominantly as well as options to manage the risk of the portfolio. So if you have a lot of small-cap names we could use the Russell 2000 Futures, you have international we can use international indices and the futures that correspond to them.
Craig: We are an active hedging group within Securian Asset Management. It is purely customizable, you can also come to us and say, “I really don’t want to have a drawdown event within my equity portfolio that’s greater than negative 30%.” And we can customize that sort of risk profile for the client, so that is the beauty of it. You have a need we can create a solution that tries to meet that need and we don’t have to run the assets, we can do it as an overlay with derivatives with a very small, modest amount of cash to back it up.
Stewart: Yeah, it’s interesting. You’re in a unique situation because you’re managing the parents’ money, this strategy for them. You’re also for insurance clients, this strategy. You can create bespoke solutions, but this is a strategy that can be used by other institutional investors as well, right? It’s not exclusive to the insurance industry.
Craig: No. When I think about insurance companies we use it within our foundation. We are also looking at using it within our pension fund and we are utilizing it for external pension clients, as well as external insurance clients. The predominant need or the known need is within the variable annuity space of you’re an insurance company that has variable annuities with guarantees, this is probably something that you’re very familiar with. Some of the other funds that are out there have not performed as they set out to perform, we are one of the best performing strategies across that universe so that is one open item.
Craig: But the rest of it if you want to use it for the general account to manage the risk of the equities that you hold, whether you’re a P&C company or a life company I think it is prudent to think about, would it be such a bad thing to have gains coming off of futures when everything else is not working out? As I think all of our balance sheets are on the midst of March in the COVID drawdown, there’s a lot of pain that occurred. Spreads widened out, we saw losses within our fixed income portfolio, losses in our equity portfolio, so it wouldn’t have been bad for any of us to have some gains coming off the risk management that this type of strategy can give you.
Craig: On the other side, within your pension plan if you are fully funded and then you have a big drawdown event in your equity portfolio, then you might not be so fully-funded. And how do you make it back? Because part of the issue is that making back losses is harder than stopping the losses from occurring in the first place and that’s where this type of strategy really makes a lot of sense. Same thing for an endowment and foundation. You have payments that you want to make every year and if you have a big drawdown event it’s more painful to make that 5% of the last five year rolling average or whatever your calculation is if your dollar amounts down 50%.
Craig: I think it meets the needs of all institutional investors. It is an educational process. We’ve gone out to talk to investment committees across the board, different institutions, and it is new and it takes a little bit of time for people to understand what we’re trying to do and why but I think everybody should be thinking about it. With interest rates as low as they are I don’t think the traditional route of moving to fixed income will work going forward.
Stewart: Yeah, I think that’s right. And insurance companies are in a really challenging environment and I think it makes sense that you’ve got to be open-minded enough to look at new solutions, take the time to learn things. Like this strategy, I mean, as you guys have obviously done a lot of work on this and I always tell our guests the person who learns the most out of this whole deal out of our audience is me because I get to hear from leading experts on these various strategies and I get to benefit from the years and years worth of research that you guys have done. So I really appreciate you being on, Craig, and sharing this story with us which is, I find it really interesting and really applicable particularly right now.
Craig: I appreciate that. I think the big message that I want to leave people with is the idea that we don’t know when the next market crash is going to occur. I hope that I’m never going to get in a car accident, I think everybody hopes that they never get in a car accident but it happens from time to time. And if you got in a car accident would you take your airbag out of your car? No, the airbag is there for a reason. And I think that’s the way we should be thinking about equity risk. We all just dial it up under the premise that we’re going to get stronger returns over time. But when those big drawdown events occur, it’s painful conversation between us and the investment committee of the board, between us and the CEO of the insurance company, when you rather have a more stable ride and why not try to manage the risk in a smart way so you still get the majority of the return?
Craig: A lot of investors think that decreasing risk will lead to poor returns or poor returns per unit of risk. That’s actually not the case, I’d love to have the opportunity to talk to you about it. But I think we all need to, as Stewart alluded to, take a step away from the traditional way of investing assets and think, is there another way that would be smarter given the current environment? None of us have gone through the low interest rate environment, the market has not gone through this type of low interest rate environment and I think we’re all worried about an inflationary or higher interest rate environment in front of us. Whether it’ll be five years or 10 years out I think it’s going to happen. And what do you do about that? Equities are the right place to be but how do you manage that risk?
Stewart: Absolutely. Well, thank you very much for being on. It’s always great to hear from industry leaders and the smart people, so thank you very much.
Craig: Thank you Stewart for having me.
Stewart: Absolutely. Just a couple of housekeeping items, the Insurance AUM Journal has announced a joint venture with CAMRADATA that’s going to bring asset manager, search selection, and evaluation tools to insurers free of charge. There’s more information on that on our website. If you have ideas for podcasts, please email us at firstname.lastname@example.org. If you like what we’re doing please follow us, like us, share our posts, all that helps our efforts. Thanks for listening. I’m Stewart Foley, and this is the Insurance AUM Journal podcast.