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Institutional Investment - May 28, 2013

I am optimistic that insurers won’t decrease their vigilance - an interview with Pascal Duval

In this month's interview, we talk to Pascal Duval, Chief Executive Officer, Europe, Middle-East & Africa, with Russell Investments, about the fixed income research conducted within the Solvency II research chair at EDHEC-Risk Institute supported by Russell Investments, the ideal fixed-income offering for insurers, smart beta in the fixed-income area and the delays to implementation of the Solvency II directive.

Pascal Duval

Russell has a fine reputation for its selection of equity managers. What led you to support fixed-income research within the framework of the Solvency II research chair that you support at EDHEC-Risk Institute?

Pascal Duval: It was important for us to continue to support EDHEC research on fixed income, which represents the major part of insurer’s assets. On average, 80%+ of life insurers’ assets are typically invested in fixed income. Moreover, we believe that while fixed income was historically managed by insurers themselves in a buy and hold posture, the current low yield environment is forcing them to expand their portfolio to non-traditional areas and strategies such as emerging market debt, loans, high yield, absolute return bond strategies, etc.

This expansion of asset classes and markets is simultaneously increasing the complexity of their portfolios in the context of Solvency II. This is why we believe that supporting EDHEC research on the impact of Solvency II on bond management for insurers is valuable for the industry. It definitely provides some interesting insights about the arbitrage opportunities that could result from the regulation. This is by the way a topic of discussion that our senior analysts have already engaged in with active fixed-income managers.

As a multi-asset fiduciary-like manager, Russell has always developed strong research on fixed-income markets and active bond managers. Actually, over the USD177 billion that we are managing, about USD40 billion is in fixed-income strategies. It is by the way in fixed income that we have been experiencing the strongest cash flows over the last three years either through direct mandates or multi-asset portfolios.

This momentum for our multi-strategy multi-manager solutions is partly coming from insurers’ willingness to capture higher yields from non-traditional markets and strategies while maintaining a strict control on underlying risks and volatility. This is indeed forcing insurers to consider the use of multiple managers. The more managers you have, the more complex it becomes for an insurer to manage those managers. Therefore you can understand that it makes sense to partner with a multi-manager who has developed the right dedicated resources in researching markets and managers with the best analytical systems to build efficient portfolios and manage underlying risks.

Last but not least, the performance of our fixed-income portfolios has allowed us to respond to this demand as illustrated by the various awards that we have received in recent years. This year, Lipper has recognised Russell as Best Bond Manager in Europe and in several European countries. We are really proud of this award, as it is a concrete illustration that our approach is as credible in bonds as it is in equities and alternatives.

What for you are the key elements of an appropriate offering for insurers in the fixed-income area?

Pascal Duval: First, insurers are very familiar with fixed income. This asset class has always represented the core part of their asset allocation. They have usually managed this asset class themselves in a buy and hold logic. Then, their duty was mainly to pick up the best bonds by looking at the quality of the issuer and the related yield.

Today, like many other institutional investors, they are facing the issue of a low-yield environment with almost nil or negative real yields on sovereign developed markets and low credit spreads on the investment grade corporate sector. This is pushing them to look for new segments and take additional risk to remain competitive. This is new for them and while they have a wealth of experience in managing underwriting risk, managing the capital market risk of a more complex portfolio is quite new.

This means that a good offering for insurers in the fixed-income area is a solution which takes care of the regulatory requirements, provides real value-added through active management, offers strong diversification relative to their other asset classes to optimise the SCR and responds to their risk management and full transparency requirements respectively through dynamic management and dedicated fixed-income analytical systems.

Typically we believe that absolute return bond strategies that rely more on managers' skills, moving away from the traditional benchmarks, are attractive in an insurer’s portfolio if they are combined in an intelligent manner. Those strategies that remain liquid and include long/short strategies on interest rates, credit markets, currencies… tend indeed to provide a higher yield with limited duration and strong diversification benefits with traditional fixed-income areas. Those features are definitely answering insurers’ needs today.

There is a lot of talk about smart beta in the fixed-income area. What is Russell’s view of these new offerings?

Pascal Duval: Smart beta fixed income can be broken down into two areas: product strategies and alternative benchmarks. The breadth of product offerings in the smart beta fixed income space is rather limited today and certainly trails that of equities (so there is indeed much talk, as managers attempt to build buzz in anticipation of strategy launches). Our view in this area is evolving as the number of smart beta fixed income strategies coming to market increases. We do note, however, that elements appearing in smart beta fixed-income offerings (e.g., bottom-up credit analysis, issuer diversification, quantitative modelling) have long been present in active fixed-income strategies, so differentiation of smart beta fixed-income offerings from their traditional active counterparts can be challenging.

Products on offer today tend to have features that reflect the current investing environment. For example, the buy-and-hold/low turnover feature is in response to today’s low yield environment: with a fixed-income portfolio’s potential total return increasingly diminished by lower and lower yields, smart beta strategies seek to limit transaction costs that eat into fund returns. This feature in turn begets up-in-quality biases, as you will only want to hold for the long term those issuers with lower risk of default. Issuer diversification tends to also play a role as, again, if names are held for an extended period you’ll want them to be in relatively small concentrations. Consistent with the foregoing, managers include quantitative models that screen issuers for their ability to service debt. While these screens likely include debt service coverage ratios and metrics of ability to generate cash, they are also proprietary. As such, and given where we are in the credit cycle and the newness of these smart beta fixed-income strategies, the efficacy of these screens/models remains to be proven.

Turning to alternative fixed-income benchmarks, some new methodologies try to address the ‘dead beats’ or ‘bums’ problem in traditional capitalisation (“cap”)-weighted indices. This is the case where the most indebted issuers (and thus those with potentially higher credit risk) tend to appear in larger concentrations in indices. Formulaic “non-price" alternative index approaches seek to lower the allocation to the most indebted issuers by assigning weights based on GDP or fundamental measures of an issuer’s ability to service debt. However, strategies involving alternative benchmarks are not without factors that require consideration. First, any formulaic tilt away from a measure of indebtedness can take a very long time to pay off, notwithstanding the recent move by ratings agencies to downgrade increasingly indebted sovereigns such as the US and UK. Second, measures of an issuer’s ability to repay debt can be subjective. Thus, investors should ensure that they understand the underlying index risk models, and that strategy investment horizons are in sync with their own.

Russell has also noted in a recent Research Note that traditional investment grade benchmarks are getting riskier from central bank intervention, featuring higher duration with low yield levels. Some of the alternative benchmarks do try to address this. However, we’ve noticed elevated credit and currency risks from higher levels of emerging market debt. For example, the GDP-weighted version of the Barclays Global Aggregate Bond Index has 10 percent more emerging market debt than its traditional counterpart. We’ve also seen a product that uses a bespoke index that blends in more than 50% local currency EM sovereign exposure. So, while these ostensibly superior composition methodologies can have more countries with higher debt-to-GDP ratios, fewer developed market ‘dead beats’ and offer a higher yield, they also have the elevated credit, currency and political risks embedded in the EM sector. Again, investors should carefully weigh these factors before committing to a strategy based on the index.

In summary, Russell is monitoring the evolution of fixed-income smart beta. While we find some of the product offerings compelling, their lack of track record combined with where we are in credit and interest rate cycles make them difficult to assess properly. Also, their buy-and-hold strategies may not be appropriate if we enter into a protracted period of rising rates; in such cases active fixed-income products with tactical capabilities may prove more valuable. Regarding alternative benchmarks, we acknowledge that non-price strategies can make better comparators than traditional cap-weighted indices. That said, investors need to be cognisant of their potential shortcomings, such as extended time to realise a payoff and increases in credit, currency and political risks from elevated EM exposure.

The Solvency II directive has been repeatedly delayed. Do you think that this will lead to insurance companies being less focused and vigilant on the subject?

Pascal Duval: We can understand that such a significant directive is debated and revisited before it begins to be applied. Now planned for 2014, many people think that the application will start in 2016 and will potentially be smoothed over several years (the findings of the Long Term Guarantee Assessment by EIOPA and the discussions on Omnibus 2 which will follow will definitely have an influence).

A lot of focus was placed on pillar 1 initially. I believe that pillars 2 and 3, focused on governance, risk management and reporting, are actually essential and represent true progress. From our discussions with insurers, they all recognise the benefits of those pillars as it has allowed them to formalise stronger governance and develop true processes for the reporting and risk management of their investments. All of this has been perceived positively and contributes to the professionalisation of asset management at insurers. The delay, which has been primarily due to the calibration of pillar 1, sounds logical to us as the rules that were fixed do not respond to the post-crisis market environment. Typically the fact that sovereign debt was not differentiated in terms of SCR was a mistake.

Now it is a pity that many insurers have spent a lot of time and money to implement pillar 1 and have forced their asset allocation to comply with those quantitative rules. I am personally optimistic that insurers won’t decrease their vigilance taking into account the progress and the hard work that has already been done.

About Pascal Duval

Pascal Duval is executive managing director of Russell Investments for Europe, the Middle East and Africa (EMEA) region, based in London. Since he joined Russell in 1994, Pascal has held various positions in Europe. He has been head of partnerships and distribution alliances business in EMEA, which included responsibility for development of new strategic relationships across the region, such as Russell’s multi-manager fund programmes for the U.K. with the Lloyds TSB/Scottish Widows Group, Italy with ARCA SGR Spa, France with the Société Générale Group and Israel with Bank Hapoalim. Pascal plays a key role in raising Russell’s profile in the marketplace and is a frequent speaker at investment conferences and seminars. Pascal is a member of Russell’s global leadership forum.

Prior, Pascal was managing director and head of Russell’s institutional investors business in the EMEA region.

Before moving to London in 2001, Pascal was based in Russell’s Paris office, as managing director of the French office. Prior to this he was director of Russell’s consulting and analytical services operations in France. He was responsible for developing those lines of business, including the ongoing development of client relationships.

Prior to Russell, Pascal worked for Wyatt Paris from 1989 to 1994 as a consultant in the company’s newly created asset consulting department. He was involved in the development of the business and performed asset allocation work, money manager searches, performance attribution and other major asset-related projects. He spent one year with Eurospet Associés, an organization and information systems consulting firm, where he consulted with financial services companies.

From 1985 to 1988, Pascal worked as a commodity trader on physical and futures markets for Riz et Denrées, an international commodity trading company.