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EUROPE - Pensions funds are likely to be paying slightly higher for passive investments since the collapse of Lehman Brothers if using synthetic replication, but are choosing to do so by over-collateralising their total return swaps, according to officials at Morgan Stanley Investment Management.

Shahzad Sadique, executive director at MSIM and head of FundLogic, the firm’s passive management operation, told IPE even though confidence about and protection against counterparty risk has improved among investors in the aftermath of Lehman’s collapse in September, many institutional investors, including pension funds, are still choosing to hold increased collateral against their investments, to protect against the prospect of counterparty default risk.

By using synthetic replication, the investor or fund manager does not buy equities but instead enters into a total return swap (TRS) with a bank counterpart. In return, the investor receives the performance of the relevant stock from the bank but leaves the tracking error risk with the bank - gaining zero tracking error, low TER and likely outperformance but leaving the investor only with counterparty risk.

However, the price of managing that tracking error risk has risen by at least 20 basis points for investment banks since the September crisis in part because investment banks are not able to lend stocks to each other and the cost of keeping equities on their balance sheets has therefore been much more expensive, according to Sadique.

“Even with some of the most sturdy institutions, [investors] are still worried about the risk they take. Everyone is hoarding cash, so all of a sudden everyone wants to own government bonds and T-Bills. And that mean the collateral fees are higher.”

He continued: “MSCI European ex UK, for example, is now priced at Index+30-40bp outperformance. We are working with a few pension funds on these structures. Before Lehmans, we could have been a lot more aggressive on pricing of this index, but probably come down 10-20bps if you use equities as collateral. If you have government bonds, the shift means this outperformance has been priced out.”

Whereas the investor might in the past have invested 5% in equities to cover counterparty risk, investors are on occasions choosing to hold a much higher percentage but are also seeking to government bonds, and US treasuries (T-Bills) in particular, raising costs again given the recent flight to quality.

The resulting impact has been to increase the overall cost of using synthetic replication, even though pricing is thought to have calmed slightly since the post-Lehman shock although volatility means the pricing improvements are still dependent at this stage on the index a pension fund investor might choose.

“We find a lot of people are now much more comfortable, whereas in October it was different,” said Sadique.

“A lot of sentiment is coming back into the market. People were fixated earlier with who might be next [to collapse], worries about the larger companies being at risk. Now they are looking at the larger universal banks and seeing injections of cash from governments to stabilise their positions.

“There is no fixed pricing if you are doing synthetic replication. But a bit of normality has returned to the market, certain indices are more affected than others,” he added.

Improved confidence in the passive management sector has encouraged MSIM to begin work on the development of a hedge fund replicator.

Sadique confirmed the firm is “in the process” of working on such a service, in a bid to tackle concerns about hedge funds’ transparency, fees and liquidity.

“[Pension funds] like the absolute returns and what hedge funds could generate as a return, but they don’t like the transparency, the liquidity and the fees. We think we could address that,” added Sadique.”

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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  • QN-2546

    Asset class: Real Estate Equity Fund (non listed).
    Asset region: Europe.
    Size: Total CHF 600m, approx. CHF 100-300m per fund investment.
    Closing date: 2019-06-28.

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