Cash Equitisation. August Introduction

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1 Cash Equitisation Carolyn Baird, Director, UK Institutional - Sales Yacine Zerizef, Senior Portfolio Manager, UK Overlay Services Klaus Paesler, Head of Currency and Overlay Strategy, UK Overlay Services August 2016 EXECUTIVE SUMMARY: Cash is a necessary evil in any portfolio. Portfolio liquidity is required to meet benefit payments and ensures capital calls can be met. However, it creates an unintended drag on the portfolio s performance as over the long term we expect returns from other assets to be higher. This is important to recognise because in today s low rate environment, every basis point of performance counts. The jargon term for unintended cash exposure found in portfolios is frictional cash, and can arise in a number of ways, for example: 1. Cash that is distributed from illiquid managers or received from sponsors but not yet invested when managers trade securities they often temporarily hold cash from a sale before it is used to settle a purchase. 2. Dividends or contributions to the fund that are temporarily not invested. At Russell Investments, we believe there is a more efficient way to manage portfolios than to simply accept this lost performance as a by-product of managing a portfolio. By equitising this cash (i.e. buying futures to replicate index returns), the fund can almost entirely capture the lost market performance. Over the long term, risky assets produce a return above a risk-free rate, otherwise no one would be invested in them. By capturing this market premium, a pension fund is able to improve its performance over the long term. Introduction Why do schemes have frictional cash? As many pension schemes continue to mature, there is an increased need for larger pools of liquidity to meet the bulkier cash flows related to benefit payments. These liquidity reserves create a drag on portfolio performance as they are not intended cash allocations within a strategic asset allocation. Typically, with schemes needing their growth assets to produce a return of at least Cash + 3% or higher on an annual basis, this unintended underperformance can have a significant impact on the portfolio s overall success in meetings its funding targets. In addition to the required benefit payments, pensions have begun to increase leverage within their Matching allocations to reduce their exposure to interest rate risk. These leveraged positions require liquid assets to be available to meet collateral requirements and margin calls. While some schemes have gilts to use as collateral, many times that pool is not enough. Furthermore, the cost of using the repo 1 market to generate cash from these gilt pools has been drastically increasing over time. Similarly to the requirement for liquidity to meet Matching portfolio needs, many schemes have relatively large currency hedging programmes in place which also require some liquidity to meet any drawdowns. As we saw in early 2016, some of these drawdowns can be substantial. 1 A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. Russell Investments // Cash Equitisation AUGUST 2016

2 A more efficient way to maintain your desired exposures and meet your liquidity needs Both of the above issues mean that schemes have been put in the position of requiring further liquidity and are needing to raise required funds from their Growth assets. Luckily, cash equitisation programmes are flexible enough to make up for the reduction of physical growth portfolio assets, whilst maintaining the market exposure. This would free up cash to meet margin requirements, whilst not materially impacting the portfolio s overall return. Cash equitisation programmes perform the maintenance, monitoring, and reporting of liquidity over long periods of time, reducing the need for investment staff to constantly raise cash from managers and monitor the liquidity on a consistent basis. This frees them up to focus on the larger issues that pensions schemes are facing in these increasingly turbulent times. The Benefits of Cash Equitisation Additional Scheme Level Return The biggest benefit of a cash equitisation service is capturing market risk premium on the cash balances within the portfolio. For example, if in any given year, the market risk premium of the portfolio is 6% and 2% of the fund is frictional cash, then the fund is forgoing 12 basis points in premium. This may sound like an inconsequential amount, but when viewed on a portfolio-level, the performance drag is substantial. On a 1 billion portfolio, this equates to 1.2 million in foregone return! Easing Operational Burden Some investors attempt to minimise this cash drag through maintaining low cash balances and generating cash from its managers on a monthly basis as needed. The problem with this method is two-fold: First, the process tends to be time-intensive for investment staff as the decisions as to the amount and the managers from which to raise the cash, and subsequently moving to funds needs to be made. Second, as the manager disinvestments tend to occur several days prior to when the cash is needed which leads to potential out of the market risk and therefore increased cash drag on the portfolio. Both of these issues are solved via a cash equitisation programme. Russell Investments believes that best practice would be to raise sufficient liquidity to maintain 3-to-6 months worth of cash requirements and overlay the cash with the appropriate futures contracts. This reduces the administrative burden of managing the fund s liquidity and the fund would retain much needed market exposure. The fund s managers also benefit by a reduction in flows in and out of the funds. Flexibility & Efficiency A cash equitisation programme also allows investors to maintain intentional cash balances. For example, when a manager underperforms or runs into trouble, it could take months for investors to find and contract with a replacement manager. Many times, they will maintain the underperforming manager until a replacement is found - to the portfolio s detriment. A cash equitisation programme would allow for quick disinvestment from the unwanted manager and into passive exposure consisting of cash overlayed with futures. Once a new manager is found, the futures are unwound in coordination with the manager funding. This strategy allows for a more flexible, risk-managed approach to managing portfolio exposures. Lastly, because Russell Investments cash equitisation platform is flexible, many of our clients leverage the platform for other derivative-based strategies, such as portfolio rebalancing or portfolio hedging, when required. An Overview of Russell Investments Service The process for cash equitisation consists of purchasing derivative exposure to the desired asset classes in the amount of cash to be overlaid. It is a relatively simplistic process, but can be daunting for those less familiar with derivatives. The majority of derivatives used in cash equitisation programmes tend to be exchange listed index future contracts. Future contracts essentially provide the return of the underlying market index they are meant to represent. For example, a FTSE 100 future contract would provide most of the return of the FTSE 100 index. In actual experience, futures return the index minus a cash rate [Index Return Risk-free Cash Return], the difference being made up by holding and receiving interest on the underlying cash. The combination of the futures and the cash should provide the same return as a physical index fund, and many index funds use futures to equitise their frictional cash. The below diagram shows how these returns work in practice: Russell Investments // Cash Equitisation 2

3 Source: Russell Investments One key difference between index futures and index funds is that futures do not require payment for the exposure. The cash is therefore immediately available for use. The futures market is extremely liquid such that increases and decreases in cash can be overlaid nearly immediately to gain desired exposures with very low transaction costs. Because futures do not contain currency risk, cash equitisation programmes will also use currency forwards in order to gain exposure to currency markets. As an example, in order to replicate 100 million in an unhedged S&P 500 index fund, a cash equitisation manager would overlay the 100 million cash with 100 million worth of S&P 500 index futures and 100 million worth of USD currency forwards to create the same return pattern. When replicating a broad index, such as MSCI World, a basket of futures and currency forwards are combined in order to match the country, market cap, currency, and factor exposures of the underlying index. An example of the potential benefits can be seen by demonstrating overlaying 5% of scheme cash with MSCI World futures. The average performance increase on a portfolio of 1 billion would be 30 basis points (or 3.0 million) per annum. 2 Annual Performance Drag from Cash 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% Annual Drag Average Source: Cash drag analysis represents forgone returns from holding 5% in cash using returns represented my MSCI World Index. Source Russell Investments as of 12/31/ Based on plan asset return of 6% Russell Investments // Cash Equitisation 3

4 Overview of Rebalancing & Tactical Views We can further enhance a cash equitisation programme by including scheme level rebalancing. As derivatives are much easier to short than physical securities, they are the ideal instrument for hedging unwanted exposures. It is relatively common for schemes to use a combination of short futures in one asset class (for example, S&P 500) and long futures in another asset class (for example, FTSE 100) to adjust the overweight in US Equities and underweight in UK equities. The combination of the portfolio cash, physical investments, and futures contracts would create a return pattern that is in line with the underlying scheme benchmark. This same long/short structure can be used to implement tactical views within the portfolio without the need to disinvest from physical managers. When used across multiple asset classes to implement strategic targets and tactical portfolio views, overlays become a powerful tool for dynamic portfolio management. Overview/example of how this can work when making an asset allocation change Lastly, because of their flexibility and ability to replicate benchmark returns cheaply, derivatives are very commonly used as a replacement long-term strategic exposures when needed. Many times a scheme will have want to change their asset allocation or perhaps remove investment in a manager that falls out of favour. Rather than waiting until all of the manager hiring decisions have been made, an overlay can be used to immediately implement the exposure changes by firing the existing, undesired manager and overlaying the resulting cash exposure with futures at the same time. You could also implement the new asset allocation with derivatives alone, subsequently unwinding the derivatives as the portfolio becomes invested physically. How Does Cash Equitisation Work in Practice? A cash equitisation programme consists of purchasing index futures in the amount of the cash balances (also known as overlaying) to replicate the portfolio benchmark. As cash balances fluctuate, futures are bought and sold to ensure that the portfolio is not leveraged or underinvested. In order to manage the cash equitisation programme, Russell Investments uses several data points that are be set forth in an Investment Management Agreement. The most important being: Portfolio Benchmark. As the purpose of a cash equitisation programme is to achieve the market risk premium on portfolio benchmark needs to be identified. Based on this benchmark, we create a portfolio that would best replicate the desired index returns. Cash Levels. We have proprietary systems to import custody data from various custodians in order to manage portfolios. Russell Investments can also build an import based on a custom file with cash balances. These can be received daily, weekly, or monthly based on the client s preference. However, the more infrequent the data, the less beneficial the equitisation programme may be as values may change without adjusting the derivative notional. Equitisation Limits. Russell Investments would typically suggest equitizing % on the cash. This would reduce the trading frequency while not drastically impacting the tracking error of the equitisation programme. Additional features that can be incorporated are: Cashflow Activity. We would typically adjust the equitisation programme for any activity within the account in a real-time basis. This would ensure that the account is fully invested at all times and under invested nor leveraged. Unequitised Cash Balances. From time to time, clients may choose not to equitise portions of cash within the portfolio, for example, by designating a certain percentage or specific value of cash which to be excluded from the overlay. This is at the client s discretion and tend to occur when there are long or short term strategic allocations to portfolio cash. On a daily basis, portfolio cash balances are compared to the notional value of derivatives held and, if required, increase or reduced to ensure the portfolio is within the fully invested/leverage guidelines. Liquidity Management The futures used for cash equitisation would require that a small portion of cash or government securities be available for initial and variation margin. Russell Investments works with clients to determine the optimal collateral mix and manages the collateralization and variation margin processes on an ongoing basis. At the inception of the programmes, typically around 15% of the manager cash values should be held in collateral in order to support the cash equitisation programme itself. Any additional cash is available to meet other scheme needs. In addition to managing collateral, cash equitisation providers should monitor the Liquidity at Risk based on the futures positions in place. Ultimately, clients are responsible for ensuring adequate cash is available for the programme, but cash equitisation managers should notify them in the event of an excess or deficit of collateral cash. Russell Investments // Cash Equitisation 4

5 Liquidity At Risk Source: Russell Investments. For illustrative purposes only. Derivatives and Currency Trading A cash equitisation provider should have a team of dedicated derivatives traders responsible for the execution of all exchange traded and over the counter derivatives. Further, these trading desks should utilise a multi-venue pure agency model to source liquidity and improve execution quality for clients. Operations & Middle Office The operations teams are responsible for ensuring the smooth running of all back office functions. This includes reconciling trade and positions with counterparties, trading and clearing brokers and custodians and transferring information electronically to these parties. The operations team ensures that settlements occur in a timely manner and any pricing or settlement issue are addressed. The operations team also managed the collateralization process. Reporting Cash equitisation providers should include a reporting system that is customisable to its clients specific needs. They should provide performance attribution reports detailing positions, cash balances, notional, and the performance of the derivatives portfolio relative to the cash balances. How Does This Work Alongside an Existing LDI Mandate? One method in which pensions have been using cash equitisation mandates is to disinvest from growth portfolio managers and use a portion of the cash (30% to 70%) as a collateral pool to meet the liquidity requirements of increased LDI hedging. The entire amount disinvested would be equitised, meaning that the pension does not lose equity exposure, but has now created additional liquidity that can be used for increased interest rate hedging. Given the current repo environment, this strategy has seen growing popularity. Below is an example of how this strategy works in practice. Source: Russell Investments Russell Investments // Cash Equitisation 5

6 Summary Russell Investments has been managing cash equitisation and derivative overlays for our clients for over 20years. In this time, our clients have benefitted by increasing plan returns and gaining flexibility and efficiency for managing cash, A derivative-based cash equitisation programme is relatively simple to implement and can be designed to match the desired asset class exposure for your fund. Commitment: Cash equitisation and rebalancing overlays are core offerings Russell Investments provides to clients, both internally and externally. In addition to our large, global, 3rd party client base, we provide derivative solutions for many of our own multi-manager and multi-asset funds. Dedicated Service: Russell is unique in the market place in that we created a team solely dedicated to managing derivative overlay assignments for clients. Our belief is that the effective implementation of an overlay programme demands a sole focus. Real World Practical Implementation: Russell Investments manages about GBP 80 billion in derivative & currency overlays*. We have detailed knowledge of financial markets and trading strategies. Specifically, this expertise spans both OTC and exchange traded-derivatives, optimal trade execution models and liquidity management. This knowledge is backed by a strong advisory, portfolio management and trading team. Russell Investments takes pride in working closely with our clients to create solutions to meet their individual needs and we would be delighted to further discuss how Russell Investments can provide the solutions you require in this challenging marketplace. * As of March 31, 2016 For Professional Clients Only. This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell Investment product or use any Russell Investment services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation. Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Any past performance is not necessarily a guide to future performance. Issued by Russell Investments Implementation Services Limited. Company No Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS. RISL First used: August 2016 Russell Investments // Cash Equitisation 6