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Derivatives-Based Beta Management Should Not Be Free!
Although often overlooked in marketing presentations that are focused on the alpha side of the equation, derivatives-based beta management is not nearly as easy or straightforward as many believe. Derivative instruments are the principal building block for portable alpha strategies because they allow investors to finance the desired market exposure at what is typically a short-term money market rate. However, complexities exist in liquid markets, such as S&P 500 futures, and even more so for market exposures that are more complicated to replicate, like multisector fixed-income indexes. The investment and operational complexities of establishing and maintaining such exposures may involve significant costs and result in additional tracking error and/or counterparty risk.
While a discussion of all of the evolving operational nuances and requirements associated with the use of derivatives is beyond the scope of this article, in short, the use of futures requires Commodity Futures Trading Commission (CFTC) and other regulatory considerations, daily margin flow management and usually a quarterly roll of exposure. The use of swaps introduces legal and contractual considerations. Other issues to take into account with swaps include counterparty risk and associated cash flow parameters and the required typical annual roll of exposure.
The last several months have presented significant tests for many of the “behind the scenes” efforts related to derivatives management. Liquidity management was subjected to an extraordinary stress test at the hands of the severe and sustained market declines. At the same time, counterparty risk evaluation became increasingly important in an environment of uncertainty for many Wall Street broker-dealers. Disentangling the payables and receivables associated with derivatives contracts at Lehman Brothers has been an unpleasant task for many asset managers and their clients.
In circumstances where there were sharp moves in the net assets of the underlying alpha portfolio, this necessitated more routine adjustment in the notional value of derivatives to align the value of the overlay with the underlying assets. The level of volatility underscored the challenges of attempts to separately manage the alpha and beta components (as opposed to implementation within a single integrated portfolio). In such “unbundled” approaches, the investor typically may bear the responsibility for all of the risk monitoring, reporting selection and oversight of separate alpha strategy manager(s) and overlay manager(s). However, the rebalancing may not have been the worst of it for these investors. One can imagine the liquidity challenges that may have been faced by investors who collateralized equity derivatives with hedge fund exposure in the event that the rapidly declining equity market exhausted their initial liquidity reserves at the same time their underlying hedge fund strategies suspended redemptions.
Nonetheless, although most portable alpha approaches probably under-performed in September–November of 2008 (it is hard to imagine otherwise when virtually all assets under-performed LIBOR), possibly resulting in under-performance for the entire calendar year, the long-term value potential of many different types of approaches, and the concept as a whole, is still very real—and perhaps even stronger than ever in some cases. That said, portable alpha is not necessarily universally applicable and as straightforward as the example referencing the S&P 500 futures implies, as liquid, cost-efficient derivatives do not exist for all commonly referenced market indexes. The broad bond market is perhaps the best example.
Bond Market Beta Replication: It’s Complicated
While a wide variety of liquid equity index derivatives are available for use in portable alpha programs, there are fewer liquid and/or low-cost options available for bond market indexes. Historically, the total return swap market has not offered reliable, low-cost replication of broad, multisector bond indexes either. Similarly, at the time of this writing, there is not a liquid futures contract on a broad multisector index. So, for investors wishing to be long, for instance, the Barclays Capital Aggregate Index via total return swaps, there are very meaningful challenges in attempting to obtain that index return precisely. The primary challenge is that broad market bond indexes such as the Barclays Aggregate contain an enormous quantity of bonds (the Barclays Aggregate includes approximately 9,000 bonds).
Recognizing the challenges in exact replication of bond indexes using derivatives, a number of innovative approaches have been developed to facilitate synthetic (approximate) replication of broad bond indexes using forward-settling liquid instruments and liquid derivatives. While a thorough discussion of the merits of such strategies is beyond the scope of this article, worthy objectives are to provide meaningful cost savings relative to expensive total return swap index replication, not be reliant on any one counterparty for the derivatives-based exposure, and to potentially deliver modest performance improvements at the same time.
Fixed-income derivatives are oftentimes more liquid than the underlying bonds, and in many cases offer opportunities to generate a higher return. The good news for investors seeking to replicate fixed-income indexes synthetically (with minimal-to-moderate cash outlays) is that it is possible to utilize a derivatives-based replication portfolio designed to closely track the return of a broad fixed-income index. For managers such as Pimco, this may be a natural extension of efforts in core-plus-bond accounts.
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