Going global top down
European pension funds looking to invest in global equities may feel that they are limited to investment managers at the micro, stock-picking level, since equity markets at the macro, country and sector level are expected to converge.
Payden & Rygel is challenging this assumption with the launch of a global equity fund strategy. The strategy is unusual not only because it takes country and sector bets, but because it uses futures derivatives to place these bets.
Robin Creswell, managing principal of Payden & Rygel Global in London explains: “The strategy is predicated on two assumptions. The first is that global economies are not converging from a correlation point of view. Far from the world being a global village where country economies tend to move in synchronicity, the correlation is becoming more random.
“The second is that a similar thing is happening in sectors. One might expect sectors within the EU to move in unison but they do not. This means that country and sector selection really can add value to the global equity process.”
The strategy uses futures, derivatives and forwards to make active country, sector and currency selections. Using derivatives reduces transaction costs, Creswell says. “Today you can execute those decisions exclusively in the derivatives market. If you take this route, you remove at a stroke an entire layer of costs that undermines active management.”
For example, to trade one Swiss Market Index contract, the bid/offer spread is two basis points. But if an investor bought an index-weighted basket of stocks on the Swiss index, they would have to pay a spread of 13 basis points.
Chris Orndorff, managing principal and head of equities at Payden & Rygel in Los Angeles, developed the derivatives-based approach to global equity investment in the US, where Payden has used it for the past eight years.
“This is not really a derivatives strategy that happens to be in equities. It’s really an equity strategy that happens to use derivatives,“ he says. “We are firm believers that country and sector selection can be the primary driver of value added in a global equity portfolio.
“We’re not saying that all global equity should be managed that way. It’s a top-down process that can complement a good bottom-up manager, because the source of our added value is very different from that of a stock-picking manager.”
Some features of the derivatives-based strategy have been designed to comfort pension fund trustees, notoriously nervous of derivatives. The strategy is long only. It uses plain vanilla, non-exotic derivatives. And there is no leveraging.
Daily calculation of value at risk (VaR) of the portfolio, available to investors on-line, provides added comfort. “If there was gearing or leverage being used it would show up in the VaR numbers,” says Orndorff. “Even going back over the past eight years, the tracking error and the standard deviation has been the same as the index. So if we were using gearing, the numbers would be higher – very similar to somebody using stocks.”
Some of Orndorff’s country and sector bets have proved highly successful. In October 2003, Orndorff predicted on Barron’s financial news service that oil would be trading at more than $40 (e30.7) per barrel. “So we went overweight energy. To enact this overweight we used exchange traded funds and went overweight in S&P’s global energy sector iShares. Energy had a fabulous run and that proved to be a good call.”
Overall, the strategy has beaten the MSCI World Index by an average of 400 basis points annually.
The strategy is available to investors either as a separately managed global equity account or a global equity fund. The Dublin-listed fund uses the euro as base currency and has share classes in all the leading currencies. The minimum subscription is e1m.
Payden expects the Dublin fund to be the preferred entry choice for investors who want to test the water or whose allocations to global equity are not large enough to justify segregated funds.
There is no price difference between the two methods, says Creswell. “We want people to choose between the two based on what best suits them, so the fund vehicle should not be materially different in price to a segregated account.”
There is no charge to enter or leave the fund, no bid-offer spread on the shares and the fee is capped. “So you come in knowing that, however active we are, all the fees – management, custody and admin – will not exceed a capped figure,” he says.
“We also expressly break out brokerage. The thing that people worry about in an active strategy is ‘how much brokerage is being generated and where is that brokerage going?’’’
One possible future use of derivative-based equity investment is to provide pension funds with a comprehensive exposure to equities that would not all be accessible through direct investment, notably because of the constraints of socially responsible investment. Creswell says that the strategy is ‘ideal’ for this purpose.
However, this may be some way off. Pension funds are only just getting used to the idea of using derivatives in their portfolios. One step at a time.