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Robust investor allocations toward ILS funds despite weak 2018

The Eurekahedge ILS Advisers Index ended 2018 down 2.93%, recording its second consecutive year of losses after 2017, during which the index slumped 5.60%. The catastrophic losses incurred by Hurricane Florence in September and Hurricane Michael in October weighed on the ILS fund managers’ returns throughout the fourth quarter of the year. While the 144 deaths and estimated US$33.3 billion damage caused by the 2018 Atlantic hurricane season were nowhere near the damage incurred by the 2017 Atlantic hurricane season (3,361 deaths and US$282.3 billion), they were enough to drag the year-to-date return of the Eurekahedge ILS Advisers Index into the negative territory. The index declined 3.68% in November alone, which turned out to be the worst month of the year for ILS fund managers. Despite the negative year-to-date return posted by the index, performance remained rather dispersed, with the majority of the ILS fund managers tracked by Eurekahedge posting meagre yet positive year-to-date returns, in contrast to their peers who suffered significant losses due to high exposure towards the US wind events.

Insurance-linked securities (ILS) hedge funds trade in instruments whose values depend on insurance loss events. The majority of these instruments are reinsurance policies that assume the risk taken by insurance companies, which in turn assume the risk taken by individuals or institutions. A reinsurance policy allows a second insurer to take a share in the potential profit and loss from the underlying insurance policy. The ILS market covers the reinsurance of various types of risk, including life insurance risk, catastrophic risk and debt risk. Life reinsurance ILS protects the insurance companies against extreme events that cause the deaths of a massive number of people, such as terrorist attacks, epidemic, or natural disasters. On the other hand, debt reinsurance ILS covers the potential losses caused by debt defaults.

Figure 1 below compares the performance of the Eurekahedge ILS Advisers Index against the wider hedge fund industry represented by the Eurekahedge Hedge Fund Index, as well as the global equity and bond markets represented by the MSCI AC World IMI Index and the Merrill Lynch Global Government Bond Index II respectively.

Figure 1: The Eurekahedge ILS Advisers Index performance since inception
Performance of merger arbitrage hedge funds versus market index and other investment vehicles


As observed in Figure 1, ILS hedge funds managed to outperform both the global equity and bond indices over the period starting in December 2015, by virtue of their immunity against volatile market situations such as the 2008 subprime mortgage crisis and the European debt crisis several years after that. The Eurekahedge ILS Advisers Index has generated 4.65% annualised return since its inception, trailing behind the Eurekahedge Hedge Fund Index which returned 6.03% per annum over the same period, while maintaining much lower correlation against the equity and bond markets.

Table 1: Table 1: Performance in numbers – Eurekahedge ILS Advisers Index vs. global equity and bond markets

Eurekahedge ILS Advisers Index
Merrill Lynch Global Government Bond Index II
MSCI AC World IMI Index
Eurekahedge Hedge Fund Index
2010
7.52%
3.64%
9.99%
11.55%
2011
(0.14%)
6.09%
(9.02%)
(1.72%)
2012
5.93%
9.08%
13.56%
7.39%
2013
7.61%
(4.67%)
23.80%
9.14%
2014
5.42%
8.37%
6.82%
5.15%
2015
4.24%
1.22%
(0.52%)
2.27%
2016
5.19%
2.69%
7.33%
4.78%
2017
(5.60%)
1.16%
17.51%
8.51%
2018
(2.93%)
0.99%
(10.10%)
(3.85%)
3 year annualised returns
(1.22%)
1.70%
4.28%
3.02%
3 year annualised volatility
5.67%
2.88%
9.77%
3.18%
3 year Sharpe ratio (RFR = 2%)
(0.57)
(0.10)
0.23
0.32
5 year annualised returns
1.16%
2.90%
3.80%
3.29%
5 year annualised volatility
4.48%
2.89%
9.92%
3.14%
5 year Sharpe ratio (RFR = 2%)
(0.19)
0.31
0.18
0.41
10 year annualised returns
3.52%
2.9%
8.06%
6.24%
10 year annualised volatility
3.65%
4.03%
12.52%
4.18%
10 year Sharpe ratio (RFR = 2%)
0.42
0.22
0.48
1.01
10 year maximum drawdown
(10.41%)
(8.88%)
(18.81%)
(6.05%)

Source: Eurekahedge

Table 1 provides the detailed risk return statistics of the four indices shown in the figure above. Key takeaways include:

  1. The Eurekahedge ILS Advisers Index was down 2.93% in 2018 and 5.60% in 2017, as ILS fund managers struggled in the face of the Atlantic hurricane seasons during the years and ended their streak of five consecutive positive years which started in 2012. Looking at 2018 returns, ILS fund managers trailed behind government bonds, which returned 0.99% during the year, while outperforming global equity markets which slumped into the red over concerns regarding the global trade tension, Fed rate hikes and slowing global economic growth.

  2. Looking over the last three and five year periods, ILS fund managers failed to generate competitive annualised returns compared to their hedge fund peers utilising other strategies. This is largely caused by the significant losses they suffered during the two recent Atlantic hurricane seasons, which wiped out nearly two years’ worth of gains and sent the index value below its February 2015 level.

  3. Over a longer period of 10 years, the Eurekahedge ILS Advisers Index generated a Sharpe ratio of 0.42, trailing behind the 1.01 and 0.48 Sharpe ratios posted by the Eurekahedge Hedge Fund Index and the MSCI AC World IMI Index respectively, but outperforming the Merrill Lynch Global Government Index II, which posted a Sharpe ratio of 0.22.

Table 2 provides the correlation values between the performance of ILS fund managers against the global equity and government bond markets, as well as their hedge fund peers. As seen in Table 2, the Eurekahedge ILS Advisers Index is very weakly correlated to the three other indices, supporting the idea that ILS investments are able to provide uncorrelated returns for an investor’s portfolio.

Table 2: Correlation matrix
Eurekahedge Merger Arbitrage Hedge Funds Correlation matrix

Source: Eurekahedge


Figure 2 provides the 12-months rolling alpha of the Eurekahedge ILS Advisers Index against both the Merrill Lynch Global Government Bond Index II and the MSCI AC World IMI Index, assuming a 0% risk-free rate. As seen below, ILS fund managers are generally capable of generating positive alpha against the bond and equity indices, with the exception of periods in which major catastrophes occurred, such as the 2011 earthquake and tsunami in Japan, and the 2017-2018 hurricanes in the US.

Figure 2: 12-months rolling alpha of ILS hedge funds vs. underlying bond and equity markets (RFR = 0%)
Eurekahedge merger arbitrage hedge funds 12-month rolling volatility vs market index and other investment vehicles

Figure 3 provides the performance distribution of all ILS hedge funds in the Eurekahedge database, including funds with life risk exposure. Despite the devastating blows dealt by the Atlantic hurricane seasons over the recent years, the median return of ILS hedge funds in 2017 and 2018 remained positive at 0.19% and 0.95% respectively. Looking at the extremes, the 90th percentile returns of the ILS hedge funds were 2.59% in 2017 and 3.69% in 2018, while the 10th percentile returns were -18.40% in 2017 and -10.29% in 2018.

Figure 3: Performance distribution of ILS hedge funds
Eurekahedge merger arbitrage hedge funds 12-month rolling volatility vs market index and other investment vehicles

The last part of this strategy profile report takes a look at the ILS hedge fund industry size and asset flows over the last few years. The ILS hedge fund industry has grown from an estimated US$29.0 billion of AUM back in 2010 to US$100.7 billion by the end of 2018. Despite the performance-based losses suffered by ILS fund managers in 2017 and 2018, the industry saw strong investor inflows which more than compensated for the losses. ILS fund managers collectively recorded US$2.1 billion of performance-based losses and US$9.4 billion of investor allocations throughout 2018.

Figure 4: Annual asset flows and AUM of the ILS hedge fund industry
Annual asset flows and AUM of the ILS hedge fund industry

The full article inclusive of all charts and tables is available in The Eurekahedge Report accessible to paying subscribers only.

Subscribers may continue to login as usual to download the full report and non-subscribers may email database@eurekahedge.com to enquire on how to obtain the full research report.

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