Death’s Certainty Beckons Hedge Funds

Nov 10 2008 | 2:26am ET

Halloween may be over but hedge funds continued to post frightening returns in October. The HFRX Global Hedge Fund Index lost 9.26% in October and three of the eight strategy indices tracked by the HFRX indices posted double-digit losses. 

But hedgies caught on the wrong side of the trade last month may do better by investing in another more stable—if ghoulish—asset class. Life settlements, life insurance policies whose holders no longer want or can afford to keep the policies, are proving increasingly popular with hedge funds. Proponents of the asset class say that it is a growing space that can yield stable returns in the high teens before leverage.

Holders Want Out, Investors Want In

The life settlements market picked up steam last year, posting its strongest growth since 2005, according to a new study by Conning Research and Consulting. The company estimates that $12 billion of U.S. life insurance face values settled in 2007.

“A combination of factors caused strong growth in the U.S. life settlements market in 2007 and is fueling our expectations for market growth through 2010,” said Scott Hawkins, analyst at Conning. “First was the continued influx of capital as institutional investors sought non-correlated investment opportunities. At the same time, we noted growing participation of smaller investors in life settlements mutual funds. Finally, demand increased among some consumers to access their life insurance equity to meet financial needs caused by the combination of a credit crunch and poor economy."

Scott Page, CEO of the Lifeline Program, which helps hedge funds find and value policies, echoes Hawkins’ sentiments. “We’re seeing a rush of people trying to sell their policies because they’ve lost their 401Ks, retirements, and pensions, and are in survival mode now,” he said.

A Safe Bet

Page said the selloff has attracted hedge funds looking for uncorrelated returns to their portfolios. “It’s not a build-and-hold strategy, but a buy-low-and-sell-high strategy because you can aggregate the policies from the consumers, package them and sell them almost as a securitization pool, but it would be more of a private placement.”

He estimates that hedge funds earn returns in the low- to mid-teens investing in the space and can bump up their returns to the mid-20s with credit facility leverage.

“The only volatility in the life settlement market is longevity. If someone lives remarkably longer than the life expectancy, then you diversify that risk by building a pool of policies,” Page said.

Page, who recommends a minimum of 300 policies for diversification, said his firm targets certain geographies based on wealth, including California, Texas, Illinois and New York. So far, he said his firm has serviced eight hedge funds including multi-strategy shops and direct life settlement funds in the $100 million range or higher.

“We believe that hedge funds need to be aware of the space and see that there are alternative assets to invest in that are much stable and uncorrelated than what they had n the past,” he said.

Taking the Plunge

Some hedge funds are already heeding the call having already launched dedicated funds to tap into the space. Newport Beach, Calif.-based Browndorf PEM has launched the Browndorf Life Settlement Funds in September to manage portfolios focused on longevity-based or life-linked assets, such as synthetic senior life settlements.

Co-portfolio managers Matthew Browndorf and Jonathan Sadowsky will use financial structures such as longevity contingent swaps and index products issued by the four major global financial institutions currently active in the space to generate stable returns with low volatility for their investors.

“With the credit markets experiencing a severe and unprecedented market dislocation, being able to offer our investors a product with more stable returns that are both uncorrelated to traditional markets and which exhibits reduced return volatility gives us a huge advantage in what I believe will certainly be a new investment paradigm going forward,” said Browndorf.

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