Liquidity Management Overlay

Transcription

1 OVERVIEW PAPER Liquidity Management Overlay March 2017 FOR PROFESSIONAL CLIENTS ONLY 1 INVESTED. TOGETHER.

2 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. 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. Furthermore, many pension funds are requiring to run higher cash balances given increased liquidity requirements arising from derivatives strategies such as LDI or currency hedging. 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. This is especially important to overcome in today s low return environment, where every basis point of performance counts. 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. By capturing the target market return, a pension fund is able to improve its performance over the long term. 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 portfoliolevel, the performance drag is substantial. On a 1 billion portfolio, this equates to 1.2 million in foregone return. For many schemes, the portion of cash held can be much higher than 2% at times. In addition to performance benefits, cash equitisation can alleviate operational pressures on the scheme. Specifically it can facilitate holding the more substantial levels of cash needed to support derivative strategies such as LDI or currency hedges. 2

3 Introduction Why do schemes have frictional cash? The jargon term for unintended or unwanted cash exposure found in portfolios is frictional cash. This can arise for a number of reasons including sponsor contributions to the fund, or distributions from illiquid managers which have not yet been invested. Over recent years cash balances seem to have been on the increase for many large schemes for a number of reasons: 1. 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. 2. Increased use of derivatives across the fund, including LDI or currency hedging. Leveraged positions such as LDI 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 currency hedging programmes also require some liquidity to meet any drawdowns. As we saw in early 2016, some of these drawdowns can be substantial. 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. Liquidity Management Overlay: A more efficient approach Both of the above issues mean that schemes have been put in the position of requiring further liquidity, however few are able to do so at the detriment of their required growth exposure. Luckily, cash equitisation programmes are flexible enough to make up for the reduction of physical growth portfolio assets, whilst maintaining the required market exposure. This allows schemes to hold a cash buffer without materially impacting the portfolio s overall return. 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. 3

4 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. An illustration of this cash drag is shown in the diagram below by calendar year. For many plans the ideal cash balance from an operational perspective may be considerably higher than 2% at times, making the preserved return benefits materially higher for some plans. Annual Performance Drag from Cash Source: Cash drag analysis represents forgone returns from holding 5% in cash using returns represented my MSCI World Index. Source Russell Investments as of 12/31/2015. Of course schemes can turn a cash management program on and off in different market environments if they want to time the periods where it will pay off most, however most don t. Overall, the return benefits of overlaying cash outweigh defensive years. Easing Operational Burden 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 allows them to focus on the larger issues that pensions schemes are facing in these increasingly turbulent times. We believe cash equitisation overlays are superior to attempting to minimise this cash drag through maintaining low cash balances and generating cash from its managers on a monthly basis as needed, for a number of reasons: 1. The process tends to be time-intensive for investment staff as the decisions to the amount and the managers from which to raise the cash, and subsequently moving to funds needs to be made. 4

5 2. As the manager disinvestments tend to occur several days prior to when the cash is required which can lead to out of the market risk and therefore increased cash drag on the portfolio. 3. Buying and selling physical holdings can be considerably more costly than running the derivative. Each of these issues are solved via a cash equitisation programme. Russell Investments believes that best practice is 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. Supporting interim exposures A cash equitisation programme also allows investors to maintain intentional cash balances. This can be especially helpful during interim periods, between investment mandates, in which a cash balance can run much higher. A cash equitisation programme would allow for quick disinvestment from the unwanted manager and into the desired 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, which can be used to powerful effect during around nimble asset allocation changes. Supporting additional tactical 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 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. The majority of derivatives used in cash equitisation programmes tend to be exchange listed sovereign bond or equity index future contracts. Bond contracts approximate an underlying standard government bond with a defined yield to maturity. Equity index future contracts essentially provide the return of the underlying market index they 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 5

6 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: Purchasing an index fund Initial position Stocks Return 100 Million Cash Buy Passive FTSE 100 Index Fund FTSE 100 Return (e.g. 8%) Purchasing an index future Initial position Futures positions Return 100 Million Cash Buy FTSE 100 Futures Market Risk Premium (e.g. 7%) Holding cash Risk-Free Rate (e.g. 1%) Source: Russell Investments. For illustrative purposes only. One key difference between index futures and index funds is that futures do not require to be 100% funded. The cash is therefore immediately available for use. The futures market is extremely liquid such that increases and decreases in cash can be overlayed nearly immediately to gain desired exposures with very low transaction costs. It is worth noting that 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. If we are also running a currency overlay for a client, then these would be coordinated together. 6

7 Tailored approach 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, or target market exposure, needs to be identified. Based on this, 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. We would typically suggest equitizing % on the cash. This would reduce the trading frequency while not drastically impacting the tracking error of the equitisation programme. Daily Adjustment: On a daily basis (typically), 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. Cashflow Activity. We would typically adjust the equitisation programme for any cash flow 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. 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, which is overlayed as part of the programme aiming for full market exposure. Russell Investments works with clients to determine the optimal collateral mix and manages the collateralisation and variation margin processes on an ongoing basis. In addition to managing collateral, cash equitisation providers should monitor the collateral levels to insure sufficient liquidity given the futures positions in place and liase with clients should a change in collateral levels be required. 7

8 Reporting Typically, our clear reporting provides performance attribution reports detailing positions, cash balances, notional, and the performance of the derivatives portfolio relative to the cash balances. This can often help improve visibility on positions for a plan. Reporting is customisable to its clients specific needs. Inclusion of Rebalancing & Tactical Views Although cash equitisation can be adopted as a standalone strategy, our clients often enhance this programme further by including scheme level rebalancing. The goal of this is to ensure that an investor s target asset allocation is held in place in a cost efficient and accurate manner, avoiding unwanted tracking error which results from market drift. As derivatives are much easier to short than physical securities, they are the ideal instrument for reducing unwanted overweight positions, as well as building on underweight positions. This framework can be bring a number of advantages over rebalancing using physicals. To illustrate this framework, we take a portfolio with multiple regional exposures with an underlying benchmark of MSCI World. In this case, there are significant regional mis-weights due to directing funds toward those markets with higher alpha targets by reducing exposure to those with lower alpha targets. In addition, this portfolio has changing allocations to frictional cash which deviate from a fully invested target. Physical Exposures vs. Benchmark over time Source Russell Investments. Data from January 2011 to January For illustrative purposes only. 8

9 In order to reduce the regional tilts while retaining the alpha, it is relatively common for schemes to use a combination of short futures in one asset class (for example, Topix) and long futures in another asset class (for example, S&P 500) to adjust the overweight in Japanese Equities and underweight in US equities. The combination of the portfolio cash, physical investments, and futures contracts would create a beta profile that is in line with the underlying scheme benchmark, with very little tracking error: Net Exposure % vs. Benchmark Source Russell Investments. Data from January 2011 to January For illustrative purposes only. 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. 9

10 Supporting asset allocation changes It is common for a scheme to make a decision to change their asset allocation, before finalising a decision on the new investment manager for the assets. 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 selling the legacy assets, and overlaying the resulting cash exposure with the target asset exposure through futures at the same time. This delivers the target beta exposure efficiently, and the derivatives can be unwound when the new target manager is finalized funded at a later date. An illustration of such move is shown in the diagram below. In this case, the performance difference between the legacy and target exposures is 2.66%. In this example, the opportunity cost is 1.3 million for every 50 million being switched. Moving to Emerging Market Equities from Global Equities: 2.66% performance deviation moving from Global to EM in this time period = 1.3m opportunity cost on every 50m being transferred Source Russell Investments. Data from January 2011 to January For illustrative purposes only. 10

11 Summary Russell Investments has been managing cash equitisation and derivative overlays for our clients for over 20 years. In this time, our clients have benefitted by increasing plan returns, 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, third party client base, we provide derivative solutions for many of our own multi-manager and multi-asset funds. Dedicated Service: Russell Investments 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 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,

12 CONTRIBUTING STAFF Carolyn Baird, Director, Russell Investments Yacine Zerizef, Senior Portfolio Manager, UK Overlay Services Klaus Paesler, Head of Currency and Overlay Strategy, UK Overlay Services For more information, contact +44 (0) Visit: russellinvestments.com/uk Important information For Professional Clients only. 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. Russell Investments recommends that clients assess their managers carefully in light of each manager s assignment and their own operating environment before entering into investment management agreements. 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 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. UKI