How to Kill a Black Swan Remy Briand and David Owyong ...

More documents

Recommendations

Info

sitated 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 underperformed 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. Bonds As A Source Of Alpha Retaining a focus on the fixed-income market, but looking to the excess return or alpha side of the equation, high-quality fixed-income strategies may be an excellent alpha source when paired with higher-risk market exposures (i.e., equities, commodities, etc.). The generally low correlation of highquality fixed-income assets to higher-risk assets may result in risk-reducing diversification. Higher-quality, diversified fixedincome strategies may also impart important capital preservation and liquidity characteristics along with structural return advantages. Finally, compliments of the painful de-leveraging and extreme market dislocation, high-quality fixed-income yields outside of the Treasury sector are currently at extraordinary levels by most measures—relative to history, relative to LIBOR and relative to the apparent downside risk. As was seen in 2008 and based on other periods of equity market decline, high-quality segments of the bond market have tended to perform relatively well. Looking across asset classes and across investment strategies during periods of financial market stress—for example, when the equity market is experiencing a material price decline—many investments exhibit a high correlation with equities. The exception is often high-quality segments of the bond market, which typically benefit from a flight to quality during such periods. The end result may be capital preservation, liquidity and the potential for excess returns when needed most. This may serve in sharp contrast to portable alpha strategies that often source alpha from riskier investment strategies that may exhibit a materially high correlation with equities during periods of equity market stress. Importantly, unlike equities and other investments, from an investor’s standpoint, bonds have the structural benefit of eventually returning the capital invested (at par value) unless the issuer defaults. Therefore, yield tends to be a reasonable indicator of return over longer periods of time for high-quality fixed-income investments and portfolios. While the shape of the yield curve and yield spreads relative to money market instruments may vary over time, the end result is higher potential returns relative to money market rates across most market environments. In today’s market environment, of course, the levels of yield provided by even the highest-quality, non-Treasury fixed-income securities are compelling. Portable Alpha Is Alive And Well 2008 represented a noteworthy test of portable alpha strategies, particularly for those employing lower-quality, less liquid and/or leveraged investment strategies in the alpha portfolio. The year also highlighted the importance of counterparty, investment and operational risk management of portable alpha programs. continued on page 50 www.journalofindexes.com July/August 2009 37
Gastineau continued from page 31 the economics of their business is based on volume and risk management. Most of them welcome the introduction of NAV-based trading because it will substantially increase trading volumes in ETFs that are not actively traded today. These market professionals will earn far more from small profits on a lot of trades than from much larger profits per share on very few shares traded. NAV-based trading also gives market makers an additional way to reduce their ETF inventory risk without incurring the costs of frequent creation or redemption transactions in lightly traded ETFs. While the conventional ETF market usually works well for investors who know how to use it to trade the largest and most actively traded ETFs, it does not serve investors in less actively traded funds very well. Trading costs are high and hard to measure in the conventional market for less actively traded ETFs. When an ETF’s trading volume is low in the conventional ETF market, its bid/offer spreads are often wide, and professional traders have little choice but to respond opportunistically to retail orders rather than to arbitrage pricing relationships. NAV-based trading increases the opportunity for ETFs based on newly developed indexes to compete with ETFs based on established benchmark indexes. It makes trading easier for advisers who are used to buying mutual fund shares at net asset value. In an extension of trading services, we anticipate the availability of executions based on dollar amounts and fractional shares provided by a financial intermediary to reduce ETF trading costs for defined contribution plans and other accounts that make frequent small transactions. NAV-based trading will facilitate the development of nontransparent ETFs that offer active portfolio management and nontransparent indexes that are not plagued with high composition change costs—in an ETF structure that protects shareholders from the cost of other investors’ fund share purchases and sales. In an earlier paragraph, I noted that there is statistically significant evidence that the average stock trades at a lower price near the market opening than near the close on the same day. A fund net asset value can be calculated from opening prices as well as from closing prices. If there is demand for it, NAV-based trading around opening or hourly portfolio values as well as the traditional end-of-day NAV calculation is possible. The author gratefully acknowledges helpful suggestions from the editor, Matt Hougan; participants at the NASDAQ OMX Symposium on Exchange Traded Funds at New York University’s Stern School of Business; and the Nasdaq OMX for the preparation of Figures 3 and 4. Endnotes 1 Net-asset-value-based trading is covered by two U.S. patents and a number of pending patent applications. 2 Individual investors probably follow similar trade patterns in stocks. The previous comments reflect conventional wisdom, not a systematic study of the underlying cause. 3 For discussion of these patterns and references to other research that has found similar patterns, see Heston, Steven L., Robert A. Korajczyk, and Ronnie Sadka, “Intraday Patterns in the Cross-Section of Stock Returns,” March 18, 2009. http://ssrn.com/abstract=1107590. We will return briefly to the issue of intraday price patterns at the end of the article. 4 One of the best articles describing this data is by Hougan, Matt, “ETFs, Spreads and Liquidity,” Journal of Indexes, July/August 2008, pp. 30–33. See also one of Hougan’s blogs comparing spreads in October 2007 and 2008, http://www.indexuniverse.com/component/content/article/31/4768-etf-spreads-widen-substantially.html?Itemid=3. The Index Universe website, www.indexuniverse.com, lists monthly ETF average spreads. Click on Section and then on Data. 5 Do not rely on the published IOPV for any purpose. 6 They will use their proprietary value calculations to estimate NAV, not the posted IOPV. 7 The most important paper on ETF trading premiums and discounts is Robert Engle and Depojyoti Sarkar, “Premiums-Discounts in Exchange-Traded Funds,” Journal of Derivatives, Summer 2006, pp. 27–45. This paper was reprinted in Bruce, Brian R., A Guide to Exchange Traded Funds and Indexing Innovations, Fall 2006, pp. 36–54. Engle and Sarkar found that ETFs holding domestic stocks had an end-of-day average premium of the closing price over the reported NAV of just +1.1 basis points (a discount would be reported as a premium with a negative sign). However, this tiny average premium is misleading. The average standard deviation of the last trade premium was 42.1 bps with a range of 17.6 bps to 142 bps for various funds. A 42-bp standard deviation is more than four-tenths of a percent of the value of the fund share. Using this standard deviation as a rough indicator of the cost of an MOC execution neglects the effect of “last” transactions that occurred before or after 4:00 p.m. Nonetheless, the average bid-asked spread for these domestic stock ETFs at the close was 37.7 bps. Neither this spread nor the reported premiums and discounts provide a useful indication of the price an investor should expect on an MOC transaction today. The study was based on a set of data that ended in September 2000. The procedures for trading ETFs around the market close have changed in a number of ways since then. The domestic stock ETFs that Engle and Sarkar studied now trade tens of millions of shares daily, but today’s less actively traded ETFs display the same variability of premiums and discounts found in the earlier data. A similar study of contemporary trading in less active ETFs would make interesting reading. Callin continued from page 37 Looking forward, what seems almost certain is that investors will demand transparency both in terms of the risk exposures in the alpha strategy and the collective portable alpha approach—and invest only in strategies where they have a good understanding of the combined risk exposure, the associated investment rationale and also the downside risk over their investment horizon. The end result may be that investors migrate out of some types of portable alpha strategies and into others. The fundamental value of portable alpha is still very much alive and well—and approaches that meet key criteria as highlighted in Figure 5 are likely to provide powerful results to long-term investors prospectively, from both return enhancement and diversification perspectives. In particular, given the extraordinary level of yield premiums available from very-highquality fixed-income assets currently, investment-grade fixedincome-based collateral alpha strategies may provide longterm investors with attractive returns in the coming years. This article contains the current opinions of the authors but not necessarily those of Pimco. Endnote 1 Source: Pimco. Analysis performed using data from the eVestment Alliance US Large Cap Core Equity universe. 50 July/August 2009
Page 1 and 2: How to Kill a Black Swan Remy Brian
Page 3 and 4: www.journalofindexes.com Vol. 12 No
Page 6 and 7: FREE subscRiption oFFER! The Journa
Page 8 and 9: David Smith Publisher dsmith@fa-mag
Page 10 and 11: Editor’s Note Got Risk? Jim Wiand
Page 12 and 13: How To Kill A Black Swan Risk and a
Page 14 and 15: Figure 2 Comparison Of Asset Return
Page 16 and 17: Figure 5 Historical Real Returns Fo
Page 18 and 19: Figure 8 Subset Of A Multi-Asset Cl
Page 20 and 21: Benchmarking Policy Portfolios How
Page 22 and 23: investor has decided to benchmark 8
Page 24 and 25: An Interview With Susan Mangiero By
Page 26 and 27: How To Minimize Your Cost Of Tradin
Page 28 and 29: Figure 2 Offer NAV Proxy Bid Using
Page 30 and 31: ETF Trading Volume Is Huge, Growing
Page 32 and 33: Figure 5 Hypothetical ETF Limit Ord
Page 34 and 35: Gastineau continued from page 31 th
Page 36 and 37: Portable alpha approaches—which e
Page 38 and 39: to write the book “Portable Alpha
Page 42 and 43: Bogle’s Corner The Fiduciary Prin
Page 44 and 45: at the direct expense of the invest
Page 46 and 47: Talking Indexes Managing The Risks
Page 48 and 49: News CVC To Buy iShares … Or Mayb
Page 50 and 51: S&P Introduces Risk-Controlled Inde
Page 52 and 53: News New SPDR Offers Twist On Mortg
Page 54 and 55: Global Index Data Selected Major In
Page 56 and 57: Morningstar U.S. Style Overview: U.
Page 58 and 59: Exchange-Traded Funds Corner Larges
Page 60: “For a strong foundation in my cl

How to Kill a Black Swan Remy Briand and David Owyong ...

Create successful ePaper yourself

Delete template?

Save as template?