Our alternative investment portfolio was looking pretty good through August of this year. All of the funds except one were in the black, and returns were on track for around a 6% gain. Then September hit.
One of our favorite alternative funds invests in reinsurance instruments. The fund is designed to earn steady returns over time from the premiums paid on the insurance policies it backs. However, there are periodic losses that the fund has to pay out, primarily when natural disasters strike.
September saw an unusual number of natural disasters. Hurricane Harvey flooded Houston, Irma caused damage in Florida, Maria ravaged Puerto Rico, and there were a couple of large earthquakes in Mexico. All of this has resulted in a year-to-date loss of close to 10% for the Stone Ridge Reinsurance fund (SRRIX).
We thought this would be a good time to review the fund, and our rationale for owning it.
The bottom line is that expected annualized returns are around 8%, year-to-year volatility is generally quite low, and the returns have no significant correlation to the returns of the stock and bond markets. Downside risk, when it does occur, tends to be less than what you could experience in the stock market. That makes the fund an excellent source of diversification in our more traditional stock and bond portfolios.
The fund invests in catastrophe bonds and quota shares. Both are reinsurance vehicles that tend to make money over time, but incur losses when natural disasters strike. A brief summary of how catastrophe bonds works may be in order.
A municipality, such as Naples, Florida, knows that it will eventually have hurricane damage. The municipality may buy insurance directly to hedge this risk, but at some point, the insurance industry will not write additional coverage on Florida wind storms.
If Naples still wants additional coverage, beyond the insurance it can buy directly, it may issue catastrophe bonds. The legal structure can get complex, but effectively, Naples issues bonds that pay out premiums of say 8% annually for the three-year term of the bond. If no hurricanes hit over this period, the buyers of the bonds get their money back and an 8% return.
If a hurricane of predetermined characteristics does strike during the term of the bond, then the investors potentially get wiped out. This doesn’t sound like such a great investment, but if we as investors allocate funds to coverage of wind storms in Florida, earthquakes in California, ice storms in Europe, and other events around the globe, much of the risk is diversified away.
It is still possible to take large losses in this fund, and the modeled downside risk is around 30% in any given year. That is a big number, but consider that stocks have lost in excess of 50% when they have experienced large downturns. This fund also generally provides less volatility than stocks, but with long-term expected returns that are similar.
Unfortunately, the nature of all investing is that in order to earn a return, we must incur risk. That risk came to pass this year for our reinsurance fund. On the bright side, in the wake of losses, the reinsurance industry tends to rebound quickly. Rates for reinsurance firm up after big losses, and returns are generally strongest during these periods.
As an interesting side note, the finance industry is frequently maligned for its focus on profits at the expense of social good. This reinsurance fund is an exception. During downturns in the fund, the money we invest is used to rebuild communities in the wake of devastating events.
We still feel quite strongly that this fund should be a part of our alternative portfolio, and expect long-term returns to be quite additive to our investment strategy
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