@Alex Towle.
It was the buzzword of 2024’s investment strategy universe – barbell strategy – how to spot it, how to cope with or take advantage of it. This was one of the most discussed topics last year.
So where do we sit in 2025 on it? With interest rates falling -possibly faster than first thought due to market volatility following the tariffs and trade war that has been instigated changing market trends are still in the picture.
However, the wider conditions are very different.
Ruth Farrugia, Group Chief Investment Officer, Resolution Life speaks with John Bradley, Vice President, Chief Investment Office, Fidelity & Guaranty Life Insurance Company, Mike Huff, Chief Investment Officer, PartnerRe, Suo Wu, Director – Risk Modelling Services, PwC, Anna Dreyer, Portfolio Manager, T. Rowe Price, about this in Clear Path Analysis’s new Insurance Asset Management, North America 2025 report, which is free to download.
The conversation this was based on is from a panel discussion at Insurance Investor’s recent Insurance Investor Live | North America event in New York.
You can read the panellists' thoughts below.
Anna Dreyer: We are strong believers in diversification across credit sectors. When stripping away the duration exposure, the sectors can and do perform differently across all but the most extreme market environments.
For our most flexible mandates, our credit spread exposure across sectors looks different from the benchmark. This typically means that we would have a structural overweight to securitised sectors, as they are less represented in the US Bond Aggregate Index. In these flexible mandates, we also like to overweight bank loans in benign market environments. Bank loans are efficient sources of spread return with low spread volatility. However, they tend to perform poorly during major credit events and recessions, so timing is a consideration.
"Rates can be a diversifier for credit spreads. However, getting
the sign of the correlation correct can be challenging."
We view mortgage-backed securities (MBS) and asset-backed securities (ABS) as the ballast sectors, as they tend to outperform more opportunistic securitised and bank loans during spread-widening episodes.
We do not see many peers taking our unique approach to sector allocation. It has been a meaningful source of alpha for us over time.
Rates can be a diversifier for credit spreads. However, getting the sign of the correlation correct can be challenging. Alternatively, for portfolios that can use credit derivatives, buying options on credit default swap indices could be a good alternative. Credit volatility is historically low, allowing managers to buy tail protection for a small upfront cost.
Suo Wu: There is an asset-based risk and there is an asset-based diversification benefit. You can do the barbell curve of high or low yield, public or private, etc., and these strategies boil down to how captured the risk is.
There is also the fund level of diversification benefits, for instance, if you purchase a fund, how you structure it will be different depending on the constrained risk and diversification benefits.
"You want to do stress testing making sure that a strategy you build cannot only be healthy in a best-case scenario but also the stress case scenarios."
There are also diversifications from the ALM perspective, which is diversifications across the asset and liability. If you move it to a higher level, then it is the entity or at the corporate level so what I would do for these diversifications is that it is better to have an intake Credit framework or an intake ALM framework so that you are able to capture the risk from the front to the end and capture those random pieces.
What is also more important is to analyse it from the scenario perspective. You want to do a lot of stress testing making sure that a strategy that you build cannot only be healthy in a best-case scenario but also the stress case scenarios.
If you consider how you want to structure your stress case scenario, you want to make it more tailored to your company’s risk, risk appetite and the risks that you care about. You want to be thinking about this from a 360-degree perspective, maximising diversification and understanding your risk.
Mike Huff: When I think about portfolio diversification, I consider it more from a qualitative perspective than a quantitative perspective. Rather than looking at a correlation matrix with estimated cross-correlations for each asset class and building a portfolio that is mathematically optimal (but heavily reliant on the accuracy of correlation assumptions), I prefer to look for areas of concentration in the portfolio, either in asset classes, geographic areas, sectors, vintages or risk factors, and ensure that the portfolio is not over-concentrated in any one area.
"When thinking about risk factors and diversification, it is also
important to focus on sources of expected return."
Reliance on correlations works well on average, over many paths for small exposures. But for larger exposures or if exposures become more correlated in times of market stress, some paths may produce outcomes that are undesirable for the portfolio. This is why it’s important to look at tail scenarios to make sure that the outcomes in the tail are consistent with risk appetite.
When thinking about risk factors and diversification, it is also important to focus on sources of expected return. If a risk factor does not provide an expected return, even if it is a diversifying risk, it won’t improve portfolio performance. FX is a good example of this; many investors believe that there is no expected return from bearing currency risk. In this case, they are usually better off hedging out the currency risk. If an investor finds an attractive asset that is not denominated in the investor’s functional currency, the underlying asset may add value (and potentially diversification) to the portfolio, but unless the investor has a “view” on the currency, they may prefer to hedge the exposure to back their base currency rather than bearing the FX risk for “diversification benefit.”
John Bradley: The challenge is that as you go out of the maturity curve, there is less diversification by asset class, especially in the liquid markets. We have become a lot more opportunistic when we work with our asset manager Blackstone and we have indicated to them where we want to add diversification, which is off the curve. They show us a lot of different opportunities, especially private structured credit leases, infrastructure, etc., and we work with them to find those opportunities, add diversification to the curve and hopefully pick up some yield from the corporates that we typically invest in.
