Towards mainstream: 2
GI: Are you saying there is a form of standardisation that is possible, even for pension funds with different liability profiles?
MC Yes, you could hedge 90% of your risk with only three or four buckets of duration and that is certainly an area of interest.
JH Our ALM group has been working on that throughout this year, due to demand from a certain segment of client and that’s about to go live now. And I think that Mike is right, you can only set up tailored swap solutions for the much bigger clients. For smaller clients the swap pools make a lot of sense.
AD On the DB side, one of the issues is the deficits. The one area of product provision we’re talking about is liability matching, but clearly that has a cost of locking into the downside, particularly if you are talking about using derivatives. You have to write those derivatives against something. As an institution we don’t like to write them against thin air, we have to write them against something we can claim against if we need to.
Again, that collateral has to be put aside and can have an impact on the pooled performance. So one thing they can do, for example, is look at bucket funds, but within the different maturity buckets you could actually try to introduce leverage. Through the leverage you may have scenarios where for a particular performance of the bucket fund, you would need less assets against it.
Clearly if it goes through certain thresholds, it’s a little bit like a margining account in a sense that you have to put more assets against it. However, as the leverage increases and performance is good you can leverage it up further. And that way you can use it to match more of your liabilities with a small proportion of assets within your fund. This would leave the fund with enough free assets for generating alpha to close the deficit.
GI Everyone seems to be excited about the idea of alpha generation. Who wants to add on that point?
TL Our process of alpha generation is based on our buy-side research department which forecasts long-term returns and tries to find pricing inefficiencies based on financial statement analysis, market positioning, discounted cash flow-analysis, etc, for the companies in our research universe. These stock picks are implemented through our portfolio management via over- or underweights against the benchmark. In some products the “fundamental alpha” is supplemented by a volatility forecast and implemented via derivative strategies.
JH It’s not rocket science. We’ve moved to a core and high alpha structure across equity and fixed income. It’s a recognition that you know how to generate alpha in these markets. You can’t do it across a $10bn (Ä8.5bn) portfolio, you’ve got to concentrate asset allocation into that core satellite structure because there’s just not sufficient liquidity out there.
I think there’s a real desire within that high alpha area to up tracking errors, up risk, and really try and generate alpha. That may well come from derivatives and hedge funds and similar kinds of products. Increasingly, pension funds are looking outside of the traditional long only space. They know that they need allocations to certain long only products, but they also need to think about risk correlation and generally how they can find the alpha. Because let’s face it, in these markets it is actually quite difficult to generate at the moment.
We also found that clients were seeing tracking errors falling and that was just a function of volatility going down. You’ve got to be careful. Clients would come in and say, we want you to take more risk and increase tracking errors. But we have to make sure that it does-n’t lead to people over trading, particularly in the cash markets, you can pay a lot more in commissions. Derivatives are a more efficient way of turning over and generating alpha, because commissions are lower.
GI I’m very surprised that this point is not made more often by proponents of derivatives. Particularly as the focus on pension funds is very much on transaction costs and reducing those. I think there are efficiency gains you can have which should result of course in overall transaction costs. I’m not sure whether the wider public and the pensions world is aware of the full potential there.
AD People will pay for performance. If you look at the alternative investment space, like hedge fund-linked products, why have we seen such a big growth? It’s because they are perceived to offer alpha, so therefore the end investors are making a greater allocation within their portfolios. So if they don’t think that they can generate real alpha within their own portfolio, other than having some sort of long strategies, they will bring a component of hedge funds into that portfolio. And they also have the advantage clearly that they can close their doors when they have too much money to manage, which is a nice situation to have.
CW The trend that we’ve seen is the institutions internalising that in terms of the next step in efficiency. If hedge funds are regarded as an expensive way to get alpha, then the next obvious step is to bring that in-house if you have the expertise and the systems and have a crack at it yourself.
TB Concerning efficiency, there is a difference between traditional asset managers and hedge funds. Hedge funds are an extension of an active managed portfolio in terms of investment universe and active risk in size and variety. When you look at alpha generated from equity investments, traditionally the active risk is arranged by over and underweighting the underlying equity position versus some kind of index or benchmark.
By using derivatives it becomes possible to engineer every kind of active risk exposure you want to have, structured with a portfolio of different instruments or packaged in one single structure. So you can increase your leverage, your active risks on the long and on the short side. But as soon as you enter the derivatives space you have a limited time horizon. If you invest in the underlying equity, you buy a stock and if it goes up you don’t care if it takes two or three months. If you invest in an equity derivative the element of time becomes an additional very important factor. You can be right about the underlying equity movement, but if you choose the wrong time frame you are going to make a loss.
So you have to establish an additional skill in the investment decision making process. That’s a key issue, and investors have to be aware of that.
CW I think the point about the timing is really important. The effect of using derivatives is that you’ve got to be right twice, which is a lot more challenging than just coming out with a buy, hold or sell type recommendation. I think it’s largely peer group pressure, and the industry has forced fund managers to look at being more creative and tailored about what they are doing. Left to their own devices, nobody would want to take that second decision. It has been forced by the way the industry has developed.
GI For benefit of the end-user, do you have other examples of structured products or portable alpha generation? I’m sure that you are all producing one or the other?
MC I think you could look also at ‘style’ investing. You could look at the difference between growth and income bias for equity selection. You could simply create a difference, you buy value over growth for example. That’s a type of alpha decision and you can package that in a warrant, and that can be held as another diversifier within a pension fund. And if value outperforms growth, it makes alpha. That’s a decision you’re taking by buying that particular style. And that list can go on indefinitely. Alpha is just the capitalisation of various views.
CW In the volatility space there are two main sources of alpha generative activity. It’s either alpha through arbitrage, which generally involves some form of mean reverting type of activity such as dispersion trading, index pairs, stock pairs or realised volatility versus implied, or its alpha through constructing a volatility position around a stated view.
GI Alpha is always much appreciated. But some pension funds have to achieve their targeted return. So any examples of how derivatives can help in this direction?
MC Certainly for targeted returns, you can see why a lot of European institutions buy collateralised debt obligations. They will provide a return in excess of Libor in most occasions. If you buy a single A piece of CDO paper, it will produce Libor plus 130 or 140, and then you think well, there is a very good chance I’ll get my 130 or 140 basis points if there are no defaults, and in a benign default environment, then that’s likely to happen. So they hit their target with a high degree of certainty.
JH From personal experience, defined contribution (DC) schemes assume a 7% or 8% per annum return, and that is net of all fees as well. In an environment where bond yields are around the 4% area, that’s pretty challenging. I think that’s broadly what most DB schemes assume too when they look at their liabilities. I’m sure that LDI processes will evolve and all these schemes will have very defined targets on an annualised basis rather than looking at returns versus an index or a particular benchmark in a bond index.
RV Some interesting products that we have seen on the markets are combining short-term equity views with long-term needs. You know that some institutional clients have quite a good view on the equity markets for the next six-12 months, and then you create a product where, if equity markets are higher after one year, you do switch towards a fixed-income-10- or 15-year product in which you’ve got 50 basis points pick-up if you’ve got it right.
A lot of institutional clients really like it, because they say they do not have a 10-year view on equities, but that they have a good opinion on a six months or one-year basis. Combining the short-term views with the long-term product works because once they have got it right, they have picked up 50 basis points above swap rates.
And if it doesn’t work out, they have some cost of course, but they can live with that because this is taken into account in advance. I think we will see more of these products, where you try to combine different views by different products which are a hybrid.
TB I don’t really agree with the statement that it is more difficult to have a long-term view on equities or equity portfolios. The problem is that clients demand the short-term view, typically 12 months. If a client is defining, for example, investment targets for the next 12 months, the problem is that these targets will probably change from year to year. As long as the investment policy is driven by short-term issues like accounting requirements and not driven by needs of the liability side, there will be a disconnect and a mismatch of investment results and the demand from the liability side in terms of investment horizon, risk and performance. And as long as the problems with the analytics on the liability side are not completely solved, we will stay in this kind of unpleasant situation that the targets will change frequently.
CW It comes back to the point that the better the institutions understand their liabilities, the better decisions you can then make on the investment side.
JH One constraint in derivatives is capacity. Our funds have reduced their equity exposure and are probably looking to increase. I think in the fixed income world there is a lot more liquidity, and we have seen the explosion of credit derivatives. But in equity land there’s definitely a constraint with capacity and quite how you resolve that I don’t know. Pension funds are enormous and they will need physical assets, you can’t just use derivatives. I think in the fixed income world there is a lot more liquidity, and we have seen the explosion of credit derivatives. But in equity land there’s definitely a constraint with capacity and quite how you resolve that I don’t know.
GI Let’s look at the area where individuals make investment decisions. DC is that kind of area, it has both institutional and also retail features. At the end of the day, the investment decision resides with the members. This is a very interesting area. The institutional world can look at what is happening on the retail side, how individuals think about investments. And most people like to see target returns, they are just looking for something certain and safe. Now that almost seems to be a contradiction in terms, investment and safety. To what extent are people actually using derivatives for DC schemes, cash balance plans or similar pensions arrangements?
MC We’ve produced some derivative products in the past for our pension clients. We used to be owners of NPI when we were part of the AMP group and had a range of funds in there which could produce returns if the markets rose, but was protected if the markets fell. They sold reasonably well initially, because we had a highly skilled salesperson selling those products.
When he left, the sales pretty much dried up. So whenever you have more complex products sold to individuals for DC schemes, it’s very difficult to move into the more esoteric structured or even leveraged space, simply because most people who put money into their pension schemes are offered perhaps a series of funds, UK general, bonds, cautious, aggressive. They don’t really know what goes into them, they just tick the box. And that is as far as their investment decisions go. Getting more complex than that is a big step.
GI In the 1990s, you had the development of capital guaranteed products and high income products, a lot of that happened in the retail world. Wouldn’t some of those lend themselves quite naturally for DC plans.
MC You would have thought so, but they sold reasonably well in the retail space outside pension funds, but inside pension funds they don’t seem to.
GI What about Germany?
TL In Germany we sold among others a series of funds which guarantee the invested capital and provide an exposure to the global equity markets. These products have been to the taste of our clients. Especially during the years 2000-2003 when the market came down and the willingness to take risk diminished or turned into risk aversion, we saw good volumes coming in. Then we saw the flows drying up and changing to the typical benchmark related products. I think this is caused by the decision-making structure within these companies. It takes time until these decisions are made. The timing could be improved.
JH I think there’s a danger as well with structured products. It wasn’t so long ago that the high income products being sold to us blew up, and pensioners on the street were getting only half their money back. There is always some derivatives story around the corner. Someone has either mis-sold a product, or done some foolish structure. So if structured products do get rolled out to pension funds, there needs to be some policing of what is actually being put into these pension plans. Otherwise there will be another scare story or another big scandal.
MB The simplicity of the product is key most of the time. The more complex the product, the more it requires disclosures that are really challenging for the end-user. Sometimes, at risk of making some products less attractive, providers should stick to a very linear and very simple structure that is easier to explain, to represent, and to disclose. That would make the acceptance of these kind of products at the end-user level a lot easier.
The structured product industry has been victim of too much complexity. Chasing high yields has definitely been an issue. The structures inevitably got complicated, they had been badly disclosed, badly sold, and in some cases misrepresented. There are specific products that the industry should have the moral strength not to put in the market when the timing is not right. I think that failures in the past have cost a lot in terms of credibility. It happens at the expense of products that could be issued and that are perfectly viable but do not get any attention. No one tends to publicise when these products go well and produce valuable returns for investors. Everything is focused on the negative stories, on the disasters in the industry.
If you look across Europe over the past 10 years, you see that most markets are dotted with some horror story of structured products gone bad. You scratch the surface, and you realize that most of these failures were caused by the most complex products in which issuers were trying to shoehorn returns in structures that were very difficult to sustain.
CW Constant proportion portfolio insurance (CPPI) is a good example. It’s actually a clever and relevant technology and when applied to a fund to create a guaranteed-type structure it allows investors to make a limited risk investment in a security that doesn’t have an associated liquid options market. However, when used to create leverage and increased participation as part of an index guarantee product it is open to abuse, as the purchaser may believe that they have an option when in fact they have a path-dependent pay-off.
AD If you can adapt it to the cyclicality of each market it does make sense. For example, the credit market doesn’t really have as deep or developed an options market at this point of time. But that is coming as the market matures. So there is this transfer of ideas from one asset class to another, this cross-pollination concept. CPPI was generally used very much in the equity environment originally. It is now very much transferred to credit and has also in time been applied to hedge funds or fund of funds products where clearly there is no liquid underlying. And that is the only way to get the options-type profile and the leverage
CW Done right, it should be providing risk transformation and choice to the end-user for a product that wouldn’t otherwise be available. Done wrong it’s dressed up and is at best ambiguous and at worst an example of mis-selling.
MB That’s key. Sometimes they are sold more like concepts than like products that have really useful features for the investors. I think that’s very difficult to balance in the industry because it sends out of all sorts of wrong signals.
AD If you look at the advanced retail markets, the Dutch market is probably one of the most advanced in Europe, a market that is very involved in collateralised debt obligation. It is not unusual for the banks based there to distribute hundreds of millions euros of CDO-linked products.
Part of that comes down to the advice side of things and what the distribution model is in that country. Why are these products successful in Holland and maybe not in the UK, for example, on the retail side of things? Because the distributor of the product is actually the bank that is putting that product together. They actually have a sales force that is likely to understand it and it comes back to this point about the skill of the sales people. And the skill of the resource within an institution and the capability and understanding, and passing on that understanding.
There is some progress and we might see these things improve, as there is some harmonisation of the European legislation. UCITS III might start to improve matters, for example, where you have to have simple language in your prospectuses and investors don’t have to read 300 pages to try and understand what’s going on. They can read the 20 page summary to get the succinct details.