Transition managers can call on a range of tools to manage volatility and risk from futures and options to exchange-traded funds (ETFs). Ceri Jones investigates
Despite the perception that stock market volatility has escalated during the last few years it has remained exceptionally low in recent months. What seems to remain, however, is an increase in the likelihood of scenarios such as geopolitical crises and natural disasters that cause volatility to spike, leaving risk harder to forecast
Transition managers have long used futures to manage market volatility and hedge against adverse currency movements. For instance, a transition from the Eurostoxx 50 index to the S&P 500 index will be at risk from the dollar rallying relative to the euro during the transition period so the manager will take a position in FX forward contracts or a long-dated FX spot to avoid a situation where there is insufficient funds to settle the S&P 500 purchase.
“Generally, we analyse risks inherent in changing the exposure in a transition and form a strategy based on a detailed appreciation of client objectives and their required pace for the transition to the target exposure,” said Cyril Vidal, co-head portfolio transitions solutions at Goldman Sachs.
“We study the resulting opportunity cost as a key factor in our decision-making. We can use derivatives such as foreign exchange (FX) overlays to reach the target exposure more smoothly and in a risk-managed way.
Most of the time clients will hedge their currency risk as the benefit usually outweighs the costs by far – this is especially true in times of increased FX volatility, for instance currency pairs such as euro/dollar have appreciated by almost 10% over the past three months.”
Limitations of derivatives
Hedging is sometimes an imperfect solution, however. One potential weakness is a mismatch between the portfolio and the index used to match it, whether that is the legacy or the target exposure.
“The effectiveness of hedging using equity futures is limited by a number of both practical and exposure constraints,” said Steve Webster, senior advisor at Allenbridge, part of MJ Hudson. “From an exposure perspective, hedging using equity index futures will mostly be limited to the more common index benchmarks, so the less the transition is correlated to available benchmark indices, the less effective a derivative hedge might be.”
Hedging against currency risk has some practical considerations, not least that the rate of the FX forward may be different from the current FX spot rate, owing to the currency interest rate differential.
Obviously, too, some emerging market currencies are restricted in the way they can be executed, requiring the underlying custodian of the client account to execute the transaction, Webster added. Asset owners that use a global custodian may also have to rely on pre-agreed terms to manage foreign exchange balances at the point of settlement, which can be sub-optimal for a transition, potentially increasing the exposure timeframe and risk.
To use futures, however, investors must have an account and be able to manage collateral, and opening such an account can be complex and time consuming, with reporting requirements adding to the legal and administrative burden.
The rise of ETFs
Exchange-traded funds are often used for the hedge where an investor does not have the operational procedures in place to implement a futures strategy. Furthermore, as transition hedging is a low margin and episodic business, banks that are mindful of their capital reserving tend to focus on their platinum clients.
“ETFs may be considered as a hedge where a client is not operationally set up to implement a futures strategy,” said Artour Samsonov, head of transition management Emea at Citi TM.
“We see three scenarios in transitions where clients use hedges. First, clients hedge market risk as part of portfolio restructure. Second, some asset management clients hedge inflows and outflows from their funds. Third, clients hedge their portfolios at macro level against market risk. We see a growing trend of using ETFs both as investment vehicles and hedging tools.”
Clients are getting more comfortable with using ETFs as a means of hedging risk. “In today’s market, clients find that setting up new futures clearing relationships is challenging. It is a capital intensive business so most brokers have focused on offering this service to high volume clients only.
Generally ETF liquidity is driven by the liquidity profile of the underlying assets. “However, ETFs’ growing popularity is improving their secondary market on-exchange liquidity, which in effect is attracting more clients,” he said.
“In the short term, using futures may be cheaper but if a client does not already have a futures clearer, operational set up may be burdensome and therefore delay the transition project.”
Physical rather than synthetic ETFs are typically preferred for use in transitions. “Because we are restructuring physical assets, we steer towards using physical ETFs that could be deconstructed into the underlying physical holdings, which often results in more efficient execution for clients from cost and risk perspectives,” added Samsonov.
Transition managers work with ETF providers to create or redeem units in an ETF, so that clients can swap a physical asset for units in a fund. This will involve helping clients restructure their portfolios to fit the profiles required by ETF providers. The timescale for ETF creation can be quick, just one or two days if the assets are liquid.
Vincent Denoiseux, head of ETF quantitative strategy at Deutsche Asset Management, said institutions such as pension funds often swap their shares via a broker for units in an ETF. “We frequently receive shares directly and issue units, with the help of our ETF capital markets team, looking at the securities brought by the investors and the benchmark they want to get into,” he said.
“This eases the transition from one portfolio to another, making it very cheap to implement. It is a service we frequently conduct not just for large schemes but schemes as small as £1m, and not only for equities but for fixed interest portfolios as well.”
Pension funds can use swaps and derivatives, and they usually do. “But for smaller funds ETFs are a great tool to park their portfolios during a transition, including FX-hedged share classes that can be used to preserve currency exposure. This removes the need for both futures and FX overlay transactions,” said Denoiseux.
“We see a significant move to passive managers, and using an ETF gives very fast exposure to a market. If a transition needs to be accomplished within three to six months, then the case for using an ETF is particularly compelling. If the timeframe is above six months then a customised mandate solution may be more competitive.”
Implementation costs can erode the projected benefits of the target investment allocation and are usually well scrutinised but as decisions to change portfolios typically take months to come to fruition, there has been greater focus recently on the potential opportunity cost incurred between the point at which the decision is made and when trading commences.
State Street produced some influential work on the issue in 2015 and concluded that the delay costs may have an impact on risk and return assumptions as well as allocation requirements, especially for pension plans. They suggest that interim exposure management strategies should be tailored to an investor’s needs and have coined the phrase ‘Event Shortfall’ to benchmark transitions undertaken this way.
It may be preferential to secure earlier adoption of the revised exposure using an interim solution to form a bridge from the time of the decision to the point when a new mandate can be delivered.
“Such early adoption can certainly have a performance impact where the new allocation or strategy is being broadly adopted across a wider group of investors, positively impacting the target exposure,” said Allenbridge’s Webster.
He looks at this as a two-part process, initially converting the legacy assets into either the final target or interim benchmark exposure while the exact required exposure is unknown, and a second phase to convert this interim portfolio into the final target portfolio. The interim configuration can be achieved by futures, an ETF or a segregated mandate.
For example, derivatives can be used to hedge both legacy and target benchmarks, while leaving the legacy investments in place for the period of the hedge. This process would involve removing the beta of the legacy investment by selling the relevant index futures and simultaneously buying the target index futures, in close co-ordination with the existing manager.
Another approach is to terminate the legacy investments and re-invest the proceeds in an ETF or index futures that will provide the required beta for the interim period and can then be converted into underlying benchmark constituents for final transition into the target mandate.
Alternatively, a more customised approach is to convert the legacy investments into an interim segregated mandate, which more closely matches the desired target exposure. This can be useful where asset screening, dynamic allocation or conditional exposure is required.