Risk Models Behind World’s Best Hedge Fund Strategy Are Getting a Lot Harder to Crack

As the best hedge fund strategy of 2023 becomes a magnet for mainstream investors, the risk models it relies on are getting a lot tougher to crack.

The strategy in question is tied to insurance-linked securities, which are dominated by catastrophe bonds (often dubbed cat bonds). In 2023, no other asset class produced a better-performing bet for hedge funds, with firms including Fermat Capital Management and Tenax Capital booking their biggest-ever returns.

Cat bonds have been around for more than 25 years and are used by the insurance industry to shield itself from losses too big to cover. That risk is instead transferred to investors who lose money if a pre-defined catastrophe hits, and rake in potentially huge returns if it doesn’t.

But calculating catastrophic risk is much more complex than it used to be. That’s because there’s a growing concentration of property in areas that are prone to increasingly frequent storms, fires and floods. Taken individually, each event is less intense than a major earthquake or hurricane. In aggregate, however, such losses can be a lot bigger, and that has major implications for the growing numbers of investors now adding exposure to cat bonds.

Traditionally, cat bonds have been used to shield insurers from the kinds of losses associated with once-in-a-generation natural disasters. But last year, those primary perils, as they’re known, accounted for only 14% of global losses, according to broker Aon Plc. Meanwhile, a category known as secondary perils “outpaced their cumulative costs in the 21st century by a large margin.”

Such secondary perils — mostly in the form of destructive thunderstorms — aren’t being consistently captured by models designed to measure cat bond risk, according to fund managers monitoring the development.