An investment firm should be willing to act as a fiduciary over the investment portfolio. Investments should be selected based on the stated needs of the client. The firm should be committed to an open, long-term approach to investing. Its mission should be to act as a prudent steward of your investments. Managing investments is highly complex. An integral component to the execution of your investment strategy is an understanding that the investment firm is acting in your best interest.
The investment firm should utilise a goals-based approach with a clear understanding of the captive’s objectives and tolerance for market volatility. A written investment policy statement (IPS) is essential to establish the structure of the investment portfolio. If an IPS does not exist, the investment manager should be able to assist the captive to develop one.
The IPS serves as a road map toward the investment goals and provides information on the approved asset classes, target allocations, and any restrictions placed on the captive by either banks providing letters of credit or the beneficiary of the Regulation 114 trust agreement.
Disciplined, consistent and repeatable
Discipline, consistency and a repeatable process are keys to investing. These are core elements to ensure that the impacts of emotion and reaction are removed from the investment process. Your investment manager should incur only as much risk as necessary to achieve your objectives. During negative market cycles, your manager should maintain a disciplined and consistent approach in order to avoid the temptation to time when to enter or exit individual investments, asset classes or markets.
Fixed income investments and interest rates
For seven years (from December 2008 to December 2015), the carnage from the financial crisis and the great recession caused the federal funds rate to remain in a historically low trading range of 0 percent to 0.25 percent. The Federal Reserve began signalling that it would raise the discount rate as early as 2012. This caused many investors to shun bonds, only to miss out on strong bond performance through Q2 2016. Bonds did lose value during the second half of 2016, as interest rates did eventually rise. However, bond prices recovered in early 2017 as interest rates declined.
With justification in hand (ie, falling unemployment rate and gradually rising inflation), the Federal Reserve implemented its first tightening of interest rates in December 2015. Since then, the Fed has followed-up with three additional rate increases in December 2016, March 2017 and June 2017. The trading range for Fed funds is now 1 percent to 1.25 percent.
Many analysts believe there is also a likelihood that the Fed will tighten again in the second half of 2017.
Looking ahead, the Fed has forecast a funds rate of 2 percent to 2.25 percent by the end of 2018. This would suggest an additional three tightenings next year. As of today, the Fed says the risks for growth and inflation are balanced. However, the Fed remains data dependent and economic conditions can vary over the next 18 months.
From a historical perspective, here is some useful information concerning the federal funds rate (for periods ending 30 June 2017):
As these numbers show, we remain in a historically low interest rate environment. Despite the possibility of a future rate increase, your investment manager should continue to manage your portfolio based on the investment policy and not make interest rate or duration bets. A conservative captive insurance fixed income portfolio may hold investment grade corporate bonds, US treasury and agency bonds and municipal bonds. Maturities are typically matched with the anticipated payout of claims to avoid having to sell a bond before its maturity date and possibly incur a realised loss if interest rates rise.
It is also worth noting that having an allocation to US treasuries, US agency and municipal bonds could have a positive impact on the pricing for letters of credit received from your bank. Your investment manager should be aware of any pricing advantages available to your captive based on the make-up of your portfolio.
Equities and economic expansions
If your captive is mature with a surplus to invest, your investment manager may be able to add stocks to the investment mix. Of course, there is additional risk with equities. However, stocks provide diversification and opportunity for growth since equities have historically outperformed bonds over the long-term. Since the end of World War II, despite the current events of the day, the ever changing economic and political landscape, and various market corrections, the US economy has managed to overcome it all and the equity markets have moved higher time and again. Here are some examples:
When your investment manager is working in your best interest to achieve your goals and has a disciplined investment philosophy, they should be able to help navigate your portfolio through the inevitable ups and downs of the financial markets.
Investment professionals should add value, first and foremost, by deeply understanding your near-term and long-term goals, clearly articulating the investment firm’s philosophy and process, developing and maintaining the investment plan, and assisting you in understanding the investment strategy.
Investment professionals should be highly trained subject matter experts dedicated to helping you achieve your goals. They should excel at educating you in the financial markets and investment process while helping you to understand the implications and complexities of the total investment plan.