Investors have pummeled insurance and financial stocks lately, but a University of Iowa finance professor is actually making money trading them.
Ty Leverty, assistant professor of finance in the Tippie College of Business, has been experimenting since last fall with a strategy of trading only the stocks of well-managed property and liability insurance companies. Although his test portfolio is extremely volatile, its value shows an increase of about 10 percent, as opposed to a broader market loss of about 30 percent during the same time.
Leverty noticed last fall that when bad financial news is released, the stocks of property and liability insurers take their hits along with life insurance companies and other businesses in the financial services sector. However, he noticed that solid, well-managed property and liability companies usually bounced back the next day.
Leverty suspects that investors unload all insurance stocks on bad news days, assuming that all of them are widely exposed to the failed financial products that led to the credit crisis and brought down so many financial services companies.
However, he said property and liability stocks hold mostly short-term assets to match their mostly short-term, low-risk policies, minimizing their exposure to the crisis.
"Those companies aren't as exposed to collateralized debt obligations or some of the other toxic assets like banks and life insurance companies are," said Leverty, an insurance expert and the Tippie College's TRISTAR Risk Management Fellow. The next day, investors realize that and buy the stocks back, and the price rebounds, he said
"When you think about these dynamics, it makes sense that property and liability insurance is a different market," he said.
He pointed out that the inability of investors to distinguish between types of insurers is not unique to the current market. Recent research shows that in the days before hurricanes Katrina and Rita hit the Gulf Coast, many investors sold insurance stocks short, but without regard to their potential exposure in the Gulf region.
"As a result, many investors shorted stocks that had absolutely no exposure to hurricane damage and would feel little or no financial pain," he said.
His strategy, then, is to buy property and liability firms on days when the financial sector gets hammered after financial news is released, then watch them bounce back after investors "come to their senses." As his profit shows, so far so good.
Leverty said the property and liability companies are benefiting in other ways from the failure of banks and life insurance companies too. For instance, as the insurer AIG struggles due to its exposure to collateralized debt obligations, many property and liability firms are buying the solid and still-profitable units AIG is selling to repay the government for their federal bailout.
Many of the experienced managers who had nothing to do with AIG's collapse are also being hired away by other property and liability companies, Leverty said.
Leverty admits his trading strategy is not for the faint-hearted, and he's invested only a limited amount of money in his experimental portfolio. He has to trade frequently to pick up the bargains, and prices are so volatile it's not unusual for him to lose all of his profit before prices rebound.
He pointed out that on one day, when financial sector stocks led the Dow down several hundred points, insurer XL Capital lost 14.5 percent of its value. The next day, the value jumped 61 percent.
Most of the companies have solid fundamentals, though, and he is also adding many of them to his long-term portfolio.