ETFs are becoming a cornerstone of insurance equity portfolios
Driven by a closer eye on performance and fees, a larger universe of available strategies and ease of investment, insurance companies have accelerated their use of exchange-traded funds.
Over the last 10 years, total general account ETF holdings has grown 15% per year, but in 2019 alone, equity ETF allocations by life, health and property and casualty insurance companies increased by 20%.1 In addition, ETF assets under management by insurance companies reached $31.2 billion in 2019, up 16% in the one-year period ended Dec. 31, 2019. And with a compound annual growth rate in the mid-teens over the past decade, usage of ETFs by insurers has doubled since 2015.2
This shift is occurring as insurers increasingly move away from fixed income toward equities and renew their focus on private assets.
But at the same time, underwriting challenges, diminishing book yields and the reemergence of market volatility have pushed insurers to seek alternative sources of income and diversification. At the end of 2019, average public equity exposure across the insurance industry stood at 9.4%, up from 6.4% 10 years ago.3
However, generating consistent alpha — true idiosyncratic returns generated by security selection or returns beyond factor exposures — is difficult. Therefore, as insurance companies sharpen their focus on performance, they have found that where alpha may not be generated, they can capture broad market exposure and factor exposures via ETFs. By utilizing ETFs to gain exposure to broad markets or factors, these investors can then focus on locating managers that can deliver alpha consistently. What’s more, ETFs often have lower management fees, multiple layers of liquidity and typically offer greater tax efficiency than traditional mutual funds.
Public equity represents a small but critical place in insurers’ asset allocations, and considering BlackRock Investment Institute’s estimate that the 10-year long-horizon return expectation for U.S. stocks is more than seven times that of bonds, the importance of equity is likely to increase. But with greater return expectations comes greater risk and so due diligence and monitoring are critical.
Due diligence is also a critical component of investing in private market investment vehicles such as private equity, hedge funds and other alternative investments. Since 2007, insurers have added $162 billion in alternative assets and continue to increase allocations.4 This increase has resulted in more complex insurance company balance sheets as well as more time required to effectively monitor, assess and allocate from public to private exposures.
Here again, as insurance companies shift their attention to more complex private assets, equity ETFs — and the ease with which to invest and monitor them — may help provide a high return on investment professionals’ limited time.
“ETFs are flexible building blocks that can be used in a variety of ways to complement portfolios,” said Andrew Masalin, iShares portfolio consulting lead for insurance at BlackRock. “This allows insurance general account investors to focus on the areas of the market — in particular private assets — where they really have the expertise to add value.”
As they increase their allocation to — and reliance upon — public equities, insurance companies are learning to understand, measure and manage the risks that come with such a move, which include concentrated positions, unintended factor exposures and the importance of rebalancing. At the same time, they are evaluating how to evolve the equity portfolio to drive greater quality and efficiency by lowering costs, substituting underperforming managers and gaining access to new markets and exposures.
Increasingly, they are finding that equity ETFs can address these issues.
Five uses for ETFs
In addition to adding liquidity to the balance sheet and providing opportunities across markets and strategies, insurance companies have found that ETFs can be used for:
- Strategic asset allocation
- Income-oriented strategies
- Capturing distinct factor exposures
- Tactical asset allocation
- Implementing sustainable strategies
Strategic Asset Allocation
Strategic asset allocation typically is a two-step process that includes determining long-term macro and fundamental views of markets and setting target asset allocations based on those views along with constraints such as capital considerations, tax, risk tolerance, time horizon and portfolio objectives. Insurance companies have increasingly turned to ETFs during the second step, or implementation of strategic asset allocation. The simplicity, low cost and versatility of ETFs make them an efficient tool to build and implement strategic asset allocation views, while their liquidity allows for ease of rebalancing to target allocations as required.
“Insurers can build entire core portfolios with ETFs,” said Paul Arendt, head of iShares insurance sales at BlackRock. “They can easily adjust those allocations as market conditions change.”
From a strategic standpoint, ETFs can be an efficient way to access international markets, which can open new opportunities and bring potential diversification benefits. International exposure can cut across developed and emerging markets, where using ETFs can allow investors to gain exposure to growth areas globally without increasing the resources needed for research and monitoring.
Equity income has become an increasing topic of discussion amid the steady decline in interest rates and yields, with dividend and preferred ETFs, which can offer tax-efficient potential sources of net investment income, a focus.
For investors, when considering dividend strategies, the discussion often centers on how best to blend holdings of high dividend payers and companies that are growing dividends, to help maximize yield and total return potential while minimizing unintended sector bias.
Along with dividend-focused strategies, preferred securities can help insurance companies generate additional investment income and diversify against their equity portfolio. Here, an ETF wrapper can provide operational efficiency as an alternative to individual preferred and hybrid securities.
Capturing distinct style factors
Another strategy that insurance companies have been using ETFs to employ is targeted factor exposures. Factors are broad, persistent drivers of risk and return across and within asset classes, and include quality, volatility, value, growth, size and dividend.
“Nearly every equity portfolio will have factor exposures, whether intended or unintended,” said Mark Carver, global head of equity factor products at MSCI. “Because of this, more investors are analyzing the factor exposures across the entire equity program and where those exposures come from. By doing so, investors can make adjustments and ensure the exposures are consistent with the investment objectives they have set out to achieve.”
Insurance companies have increasingly used style factor ETFs to efficiently manage unintended factor exposures. They are also used to build resilience in long-term equity positioning, identify and replace underperforming active managers and replicate desired exposures within a liquidity sleeve.
A BlackRock study of over 400 insurance portfolios found the average equity portfolio, as of Dec. 31, 2019, had notable, and not always beneficial, factor biases. Insurers had exposure to unrewarded factors such as volatility, which can drive uncompensated risk in portfolios. There was also negative exposure to small company stocks, momentum and quality style factors, which can detract from portfolio returns. This suggests that insurers may be positioned away from the rewarded factors, and could thus benefit from adjusting these exposures.
These tilts are likely unintended for many portfolio managers and arise as an inadvertent consequence of security and/or fund selection. Allocating to single-factor ETFs can correct for undesired factor exposures without changing managers or individual stock selection.
The extreme market volatility and uncertainty this year has driven home the importance of equity resiliency, as traditional defensive positioning through sector allocation would not necessarily have provided lower drawdown than the broad market. Here again, factor ETFs may have been able to help.
Quality and minimum volatility single-factor ETFs can help bolster equity resiliency. Quality-oriented portfolios provide exposure to profitable companies with stable earnings and strong balance sheets. Minimum volatility is a defensive strategy that seeks to limit a portfolio’s downside or reduce risk, which can help smooth out volatility spikes.
These attributes can help provide resilience during market downturns, when the fundamentals of high-quality companies — strong historical profitability, consistent earnings and low leverage — become broadly sought-after attributes.
Factor ETFs can be a source of liquidity and precision in portfolios, allowing for quick and cost-effective implementation, helping managers free up time to re-evaluate individual securities and focus on proprietary alpha generation.
Tactical asset allocation
The fourth main strategy that insurers use ETFs for is tactical asset allocation, or quickly adding risk or expressing a market or sector view. In this case, one of the major benefits of using ETFs is that they can provide price transparency in volatile markets.
In fact, in March 2020, as the Cboe Volatility Index, or VIX, climbed to a record 82, insurance companies turned to ETFs in an effort to manage risk and minimize losses, trading $24.6 billion of fixed income and equity ETFs. Of that amount, about $12 billion were in equities.5
In terms of sector exposure, certain industries are benefiting from secular trends, demographic and social changes, and the impact of technology developments. These trends are leading to growing performance dispersion within sectors and industries, and investors are looking to re-align their portfolios accordingly.
Two examples are healthcare and technology. Innovations within the healthcare industry are accelerating while technology has become a paramount input into almost all areas of global economies and society.
Implementing sustainable strategies
ETFs have become an effective way for insurance companies to incorporate sustainable strategies, which are increasingly becoming a core component of institutional portfolios.
According a report from BlackRock called The Big Shift about the insurance industry’s use of ETFs in equity portfolios, global insurance companies have led sustainability efforts in the industry and have cited improved risk-return ratios and the economic benefit of incentivizing companies to operate and invest for the long term as their main reasons for pursuing these goals.
“Our analysis for insurers showed that it would be possible with ESG indexes to improve the ESG profile of hypothetical portfolios and improve the risk/return characteristics,” Carver at MSCI said, citing a November 2020 report from MSCI titled Managing Portfolios in a Low-Rates Age.
ETFs in this context can be used in creative ways. For example, P&C companies with exposure to climate risk can use sustainable ETFs to invest in companies that can potentially reduce liabilities, particularly those most affected by extreme weather events.
As the ETF industry has grown and evolved to include more geographies, industrial sectors, investment factors and styles, insurance companies have relied on them more and more to help simplify their public equity allocations. For these investors, ETFs offer a cost-effective, singular line item to provide diversification across markets, potentially improve risk adjusted returns and pursue extra income while maintaining flexibility in their portfolio.
“BlackRock and iShares have been partnering with insurers for more than a decade,” Black Rock’s Arendt said. Citing data as of Dec. 31, 2019 from SNL Financial, he added: “We’ve seen ETF allocations grow more than four times faster than balance sheet assets over this time period. We continue to find benefits accruing to insurance general accounts for their use of ETFs and have found the fastest adoption in equities.”
1 Source: Black
2 Source: S&P Dow Jones Indices (https://www.spglobal.com/spdji/en/documents/research/research-etfs-in-insurance-general-accounts-2020.pdf)
3 Source: Black Rock, S&P Global Market Intelligence. Data as of Dec. 31, 2019.
5 Source: S&P. Data as of March 31, 2020.
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