It is unusual to discover something where the reality is as good, if not better, than the theory. One particularly savvy client set us the challenge of implementing an equitisation strategy for their European equity portfolio in early 1999. Although we run over $4bn (at September 30 1999) of European equity specialist accounts for a wide variety of institutional clients located across Europe and the US, this was a new project. The three-year equity return for this particular client was in excess of 20% a year and sterling had produced an annual return of around 6% over the same period. Based on these figures, we estimated that full equitisation would have generated an additional 75 basis points each year – free money!
For what is a very simple and natural process, equitisation seems a complex term. It basically means indexing residual (or ‘frictional’) cash in equity-benchmarked portfolios such that it produces benchmark returns. Certain American consultants have published a lot of good research, most notably Frank Russell, into why ‘cash is trash’ in fully invested equity portfolios. The rationale is that if one assumes equities outperform cash over the long-term then by indexing frictional cash in equity portfolios, performance can be enhanced.
Our task was to find one simple, tradable index that minimised risk against the benchmark. Although the euro was only a few months old at the time, it was already clear that the Dow Jones Euro Stoxx 50 Index contained many of most liquid and tradable stocks in Europe. Our backtesting, though admittedly over a limited period, showed that the DJ Euro Stoxx 50 Index is one of the best proxies for the broader based FT/S&P-AWI Europe ex UK Index. In addition, the futures contract based on the DJ Euro Stoxx 50 Index was the most liquid European future in early 1999. This made it the most appropriate for equitising cash.
There are two choices as to who runs the equitisation programme: the manager or the custodian. I would liken this to the difference between choosing a manual and automatic car. The manager, seeing the corner coming, should be able to react ahead of time whereas the custodian bank can only operate passively. This means that the manager should perform better than the custodian. The mechanics are fairly simple: an updated cash position must be calculated every day and the corresponding value of contracts bought or sold depending on whether there has been a net sale or purchase of stocks within the portfolio. Equity index futures generally operate over a three-month cycle and require to be ‘rolled’ forward approximately one week before expiry.
One of the best aspects of a cash equitisation strategy, in addition to generating a higher return for client, is the fact that it gives the portfolio manager more time to think. By this I mean that within a fully invested portfolio, every great sell idea must be matched with an equally good buy idea. If all available cash is equitised, pressure to find an immediate home for a great sell idea is reduced. This buys the portfolio manager more time to evaluate his or her next move, resulting in fewer rushed decisions. Notwithstanding this flexibility, we remain committed to running fully invested portfolios to maximise alpha generating potential.
There are several housekeeping items that require attention. Firstly, the investment management agreement must explicitly permit the use of equity index futures. Several clients do not permit the use of derivatives for a variety of reasons and this position has to be respected. These futures must be traded on a recognised exchange and the free payment of cash permitted. Futures require the daily calculation and movement of variation margin. The portfolio’s daily cash forecasts must show the amount of available cash committed to futures and the strategy has to be implemented one business day in arrears.
Furthermore, client portfolio reporting and risk management systems have to be upgraded to reflect the impact of equity index futures. One very welcome side benefit of equitisation was the reduction in predicted risk against the benchmark – firstly less cash means lower risk against a fully invested benchmark and secondly the future generally has a lower predicted tracking error against the benchmark. We discovered that each 2% of cash equitised represented a 0.1% per annum reduction in predicted tracking error. This figure obviously depends on the precise shape of the portfolio and benchmark.
We started to equitise cash for a client’s portfolio on May 5 1999 and our experience to date has been very positive. Several of the portfolio managers whose initial reaction was sceptical have become converts and we are currently exploring its potential with other clients. One major issue for US clients is that contracts based on the DJ Euro Stoxx indices do not have CFTC (Commodities Futures Trading Commission) approval and hence cannot be employed for US domiciled and/or regulated accounts. The alternative solution is to self-build a European benchmark tracker using single country index futures (most of which already have CFTC approval) but this becomes difficult to manage and requires complex rebalancing.
Despite relatively paltry European equity returns since May, the results from this account have been very encouraging and the client is delighted.
Provided you buy into the concept that equities will outperform cash over the long cycle, equitisation of cash strikes me as one of very few ‘no brainers’.
Richard Alexander is responsible for all European specialist clients at Scottish Widows Investment Management in Edinburgh