Can one lose his capital by investing in funds in Euro? Credits: Pexels
The purpose of this note is to explain why start recycling funds in Euro.
Why recycle funds in Euro?
Funds in Euros have been a very successful financial asset over the last 20 years. They allowed life insurance investors to benefit from the secular decline in bond yields with a guarantee of capital and a ratcheting effect on annual performance.
As a result, many investors use Euro funds as risk-free assets on life insurance contracts. Money market funds are no longer used because they have a structurally negative return (the bank base rate is set at -0.40%) plus the contract management fees (1 to 1.5%). Finally, on diversified assets, the capital is not guaranteed and additional management fees are added to the previous ones.
Many investors, however, neglect the following risks:
1. Euro funds are subject to a systemic risk of rising long-term rates.
Euro funds are often invested mainly in bonds with an average maturity of around 5 years. The share invested in shares is limited by the capital guarantee. In the event of a sharp rise in long-term rates, the fund backing portfolio in euros may have a negative valuation. This scenario has rarely happened in the last 20 years as long rates have steadily declined to 0% in Germany. However, we can think that the accession to power of Donald Trump will result in a "re normalization" of long-term rates to a natural rate of equilibrium that corresponds to the growth of nominal GNP long-term is around 5% to 6% for the United States and Europe. Thus, for the first time since 1997, the decline in equities we have seen since October 5, 2018 is not accompanied by a simultaneous rise in bond funds. Interest rates are no longer falling. This is a break in an anti-correlation that we have seen so far in a "secular" way.
2. Funds in Euro are not necessarily segregated from the insurer's capital.
If the fund in Euro is poorly managed in the face of systemic risk (partial default by Italy, sharp rise in long-term rates), it is the insurer who must ensure through his own funds the minimum performance of 0% (effect of annual ratchet). In the event of bankruptcy of the insurer, it is the insurance reserve fund which would limit the losses of the insured.
As a result, Euro funds are not strictly speaking a "risk free" investment, but a risk-based investment of the insurer with a guarantee of space. Admittedly, such a risk remains very low, as proved by the crisis of 2008 or the crisis of the Euro. The ACPR and the Banque de France then showed the robustness of their control of insurance and we saw no bankruptcy insurer, despite the deep restructuring of the Greek debt (bankruptcy of Greece) and soaring rates sovereigns in Southern and peripheral Europe (Italy, Portugal, Spain and Ireland).
3. Holders of funds in Euro may be legally subject to a "gating" clause.
In fact, the General Terms and Conditions of many life insurance contracts and the "Sapin 2" Law authorize the insurer to suspend or cap redemptions and arbitrages on funds in €, on an interim basis, when exceptional circumstances arise. require and if the interest of the holders or the public orders it. This action is called: Gates or "Gating".
This clause was rightly negotiated by the insurers with the ACPR, the Insurance Supervisory Authority, on the proposal of the Banque de France via the Sapin 2 law. This clause implies that if long rates rose sharply by more than a certain amount level, some insurers would be justified in activating this "gating" clause on Euro funds, as some hedge funds have done in the past. The insured could then either keep their fund in Euro for a fixed period (for example 5 years) with a return linked to the average yield of the portfolio (around 0.8% currently), or take the loss related to a revaluation of the portfolio backed by the new market conditions.
Admittedly, such a scenario of sharp rise in interest rates is still unlikely due to bond purchases by the ECB via QE (Quantative Easing) or even LTRO. However, one can think that the new policy of D. Trump can reinforce the probability of such a scenario in the USA, with a risk of certain contagion on Europe.
How to estimate the risk of loss linked to a gating on funds in Euro?
It can be assumed as a first approximation that the average investment of funds in Euro is a bond portfolio with an average maturity of 5 years. Assuming that the average profitability of the portfolio can be estimated as the average of long-term rates over 4 years, we have an average portfolio rate around 0.75%.
What has been the evolution of German long-term rates since 2009?
Bloomberg Source, Evariste Quant Research, Bloomberg LP is not responsible for this analysis.
If we assume that the average duration of this portfolio in euros is around 4 years, an upward sensitivity of rates around 3 / 3.5%. If we suppose that the 5-year rates can go back to their 10/20 years average, around their "natural rate" of 4 / 4.5%, we would have a rate rise of 4%, ie a potential loss of the standard portfolio around 12/15%. In practice, the loss would probably be more limited thanks to accumulated and undistributed capital gains reserves.
How to recycle funds in Euro?
Euro funds accumulate their performance at the end of each year. January is therefore an ideal period to recycle funds in Euro without losing the return accumulated over the year.
The following investments can be used to recycle a fund in Euro:
- A basket of funds for asset allocation
- A dynamic asset allocation on indices (via ETFs or actively managed funds) with strict risk management, in particular maximum loss via mandated management
- A short term credit fund
- A long short equity portfolio with a controlled risk
Life insurance investors are exposed to a financial and legal risk in the event of the setting up of "gating" on funds in Euros by insurers. In fact, in a scenario of rising long-term rates at average historical levels of 4/5%, the mark to market of funds in Euro could show a loss.
Many insurers are aware of this risk and promote a recycling in "unit of account" portfolios of funds in Euro or limit the total investment in a fund in Euros. It seems important for an investor to work now on such strategies for recycling funds in Euros without waiting for a rise in long rates that could impact the status "risk free" funds in Euros, the preferred placement of the French.
Evariste Quant Research
Independent Financial Analyst – Member of SFAF
DISCLAIMER: This message is for informational purposes only and does not constitute an offer of products or services, or an offer, recommendation or solicitation of an offer to provide or sell an investment advice or service. financial instruments.