Improve the tradeoffs between risk and reward with capital efficient investing
Jared Gross: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today’s episode on Derivatives and Capital Efficiency has been recorded for institutional and professional investors. I'm Jared Gross, head of Institutional Portfolio Strategy and guest host of the Center for Investment Excellence. With me today is Dan McNeill, head of Derivatives for JPMorgan Asset Management. Welcome to the Center for Investment Excellence.
Daniel McNeill: Thanks for having me.
Jared Gross: Dan thank you, let’s go ahead and jump right in. One of my recent themes has focused on reaching portfolio objectives in changing markets and the most recent topic that you and I have explored is capital efficiency.
And what we mean by capital efficiency is identifying opportunities for institutional investors to take capital that is invested inefficiently and replace that investment with a synthetic alternatives, essentially use a derivative to replicate what is currently being done in securities and thereby free up additional capital that can be invested elsewhere at a higher level of return or to generate improved diversification or other portfolio benefits.
And in the background of this is this challenge that all investors face today which is the market environment is challenging for those that have high long term return expectations and the use of traditional liquid market investment strategies is unlikely to produce returns on par with what we have enjoyed not just in the recent past but over the last several decades.
And there are some paths that investors can go down to hopefully improve their performance, one is they may consider taking on a bit more risk in the markets but that has some tradeoffs. They may consider moving capital to alternative asset classes that have some level of illiquidity but generate potentially higher levels of return and alpha but there’s constraints around that model because of the illiquidity and other portfolio allocation constraints.
And so even if you pursue both of those paths -- a slightly riskier strategy, the use of alternatives -- you may still not be able to ultimately generate the types of returns that investors need. So this option that we're going to talk about today which is capital efficient investing and the role of derivatives is a third path that investors can follow to improve the potential returns on their portfolios.
And the fundamental insight, and Dan you’re going to spend a lot of time talking about the implementation side of this, but the fundamental insight is that certain investment strategies that are common across institutional portfolios are capital inefficient and what we mean by that is two things. One is that there’s the potential to simply replace the traditional form of investments with something that is synthetic and free up capital and the second theme or the second concept is that there is an opportunity cost, that pursuing some of these low-cost beta-driven strategies in and of itself hinders performance because that money does have the potential to be allocated in more interesting ways across the global opportunity set.
And just to give two very basic examples that we will explore in more detail many institutional investors have exposure to passive equities. Now there’s a common misconception as I think about it that passive investments are low cost, in fact they are cheap. You don’t pay your manager very much to run a passive strategy for you but that does not necessarily mean that they are low cost. There is an opportunity cost to allocating to a program of buying passive equity that invests in shares because you can easily obtain the same market exposure through a derivative contract that requires only a fraction of the capital to be invested.
Similarly large holdings of treasuries have the same characteristics, they require a lot of capital to hold the physical bonds when in fact using futures or some form of total return swap you can replicate that exposure essentially perfectly and free up a lot of capital. And what is often the case is that the most inefficient sectors in a portfolio are also those that have the most efficient and most liquid and most accessible derivative markets.
And so this works out very neatly for investors which is that they can at the margin improve their portfolio performance by replacing some of this inefficient beta exposure with derivatives and then take that capital and invest it more productively elsewhere. Now we'll come back to that last point at the end of the call. The purpose today is really to explore the mechanisms by which investors can effectuate these changes in their portfolio and make this a real strategy.
So with that let me pivot to you Dan and ask when you work with institutional investors on implementing a derivative strategy what are the steps that you typically go through to make that happen?
Daniel McNeill: Thanks Jared. When we think about derivative implementation into portfolios the most important starting point is that the outcome that you’re seeking should really drive the implementation and primarily it should be simple, it should be well controlled and it should be very transparent about what is going on with the derivatives in the portfolio and how they are driving or changing the overall portfolio outcome.
And as you said in many cases the implementations that we are doing for clients happily meet those requirements because they are using the most simple and transparent derivatives in the market because many clients are looking to passive equity replacement through the most liquid and transparent derivatives in the world which are large cap US equity futures, S&P 500 futures and those are relatively simple to talk about the implementation of.
But nevertheless clients are coming to us and they’re really asking us what is the most efficient way and the simplest way for me to do this, to get these contracts into the portfolio; can you help us with the setup; can you help us with the outcome; can you help us with the overall implementation. And the answer to that very often is yes we can.
Jared Gross: So Dan let’s maybe drill into that a little bit. So I'll just create a hypothetical example, a client has $100 million of US S&P 500 passive equity beta exposure in their portfolio and they say we would like to engage in a more capital efficient form of obtaining this beta exposure. So as you said there’s a initial choice which is what is the derivative instrument that you’re going to choose to replicate that beta and then there are some of the operational elements underneath, how much cash, how much collateral, how do you manage that across time.
So maybe take us through those two steps, first what are the pros and cons of the beta selection and then dropping down a level how do they set up the structure in such a way that it can be managed effectively.
Daniel McNeill: The choice of derivatives contracts in some cases is obvious. So in the example that you’ve chosen happily there’s a very, very clear outcome which is S&P 500 futures. So they are the leisure investment choice for US large cap equity and in some cases you may have to choose between different types of derivative contract but we'll talk about that later.
But in this case you say okay we know we want to have the ability to trade S&P 500 futures contracts so now let’s think about the practicalities of actually doing that. Well what do you need when you have an account that’s able to trade futures? Well the first thing you actually need is a clearing broker. So you need a broker that stands between you and the exchange and deals with effectively the margining requirements that the exchange imposes on counterparties in the futures market.
So effectively you trade the futures and they’re your futures, they go into your account but the clearing broker stands between you and the exchange making sure that you’re paying the margin that’s required in times but then they can pay the margin that’s required by the exchange and very often those margins are exactly the same but the clearing broker may have extra margin requirements that they want to just get a little bit of extra comfort dependent on the client.
Jared Gross: Now Dan in that space in most forms of implementation a client would hire a manager such as JPMorgan to run that account for them. And so the actual contact with the clearing broker would not be done at the client’s level although for certain large, sophisticated clients they could certainly engage in this type of investment activity directly, is that a fair statement?
Dan McNeill: Yes that’s right. So many clients will come to JPMorgan and say can you help me with the setup and the engagement of a clearing broker or multiple clearing brokers. So what we would normally do is we would appoint two clearing brokers to an account, a primary and a backup. It’s unlikely you’ll ever need the backup because these markets are extremely liquid and extremely transparent but we always like to have a little bit of safety around a primary and a backup.
So we would go to the clearing broker, they would know us very well, they know we’re the large institution who understands the client’s needs, they would take a lot of comfort from the fact that we are bringing this client to this broker. They would want us to talk a little bit about the nature of the derivatives investments or why is the client or clients engaging in derivatives. And in the example that you have given it’s a very simple reason so it would be very simple for the clearing broker to understand.
And they would take a lot of comfort in the fact that a manager like JPMorgan was overseeing the implementation of those futures contracts and therefore the setup would be relatively simple.
Jared Gross: And the other element is the margining and the collateralization of the account to make sure that the client remains fully invested across time. So again that’s something that we as a asset manager could handle on a client’s behalf but maybe let’s dig into it a little bit just so people understand exactly what goes on under the hood as it were.
Daniel McNeill: Yes so if we put a few numbers against this to make it real world. So in your example a client wants to get $100 million of S&P 500 futures, well the exchange when you would enter into those contracts they require from the clearing broker approximately 6-1/2% initial margin so $6-1/2 million of cash or liquid securities to be pledged to the exchange. And that is effectively you can think about as a highly leveraged investment.
Now of course that’s not the end of the story, the next thing is that the clearing broker’s responsible for paying that margin to the exchange but the clearing broker also needs to get that margin from our clients. And what they may say is well look 6-1/2% is a pretty low number, it’s a pretty leveraged investment so really to give me a little bit more comfort I would like you to pledge perhaps double that. So I want you to give me 13% initial margin in the account so $13 million to be held and managed by JPMorgan as well as the futures contracts.
Now a time then goes on and the market moves around there will be daily variation margin calls. So if the client makes 1% on that 100 million they’ll make $1 million and the clearing broker will pay that money to the client. But conversely if the market goes down and the client loses $1 million then the exchange will demand that money from the clearing broker who will then in turn demand it from the client.
So JPMorgan’s role in that is keeping an eye on the overall margin making sure that never gets to the point where the margin is depleted so much that there’s no cash left in the account. And there’s the balancing act but there’s obviously to maximize the capital efficiency that is the purpose of this overall exercise you really want to minimize the cash that you’re putting up in terms of margin but minimizing cash means increased leverage, means increased risk.
And therefore there’s a prudent middle ground where you say well, you know, let’s not leverage the account to the max, let’s take something that’s a little bit more sensible so that we don’t have to constantly be asking for extra cash to be posted from somewhere so we maintain a buffer in the account and we would work with the client and the clearing broker to establish the guardrails, the buffer amount, the expectation of how much cash will be in the account at any one time for the futures position that the client needs.
Jared Gross: And I think that raises a very interesting question because there is a separation between the mechanical leverage that the use of derivatives creates or allows an investor to create in their account versus the strategic decision that a client thinks about when they decide to become more capital efficient and while they are not unrelated they are different things.
And so, you know, to maybe provide a more broad based example using the same idea of $100 million S&P futures exposure if a client simply replaced the shares with futures and invested the full $100 million in cash they would essentially have replicated the S&P 500 exactly, their returns would mimic a passive investment in the index. Now to some extent there wouldn't be much point in doing that unless you were going to do something with the cash beyond letting it sit in the bank account.
And so the decision on the client’s part to deploy that capital elsewhere is one of the ways that they can improve the overall performance of their portfolio but a client could have deployed 20% of that cash, they could deploy 30%, 40% up to the level that would require collateral at the exchange and clearing broker level but there’s no obligation that they in fact use all of that leverage potential.
And in fact I think most clients who think about this topic at the strategic level are not looking to maximize leverage. What they’re looking to do is maintain a very conservative approach to the collateralization of their derivative positions ensuring that they never have issues with margin and so forth and taking a meaningful but smaller than what is possible piece of that capital and moving it into something with a higher level of return elsewhere. Is that kind of a fair assessment?
Daniel McNeill: That’s absolutely right. The thing that we're unlocking here is the client’s option to deploy some of that capital elsewhere and that’s the flexibility that they really value but again yes they’re not looking for a max type, hyper leveraged account because actually there’s really little advantage to that in terms of the potential downside of unexpected margin calls or the things that can happen when you have a lot of leverage in a single account.
But there’s remember at the end of the day the clearing broker may look across at those clients and see a very large, very conservative, very well-funded overall client but they’d also look at the derivatives only account and they’ll say well why is that bit so leveraged if you’re really doing it to account.
So there’s definitely I think all parties tends to go towards the conservative side of the funding of the account and that suits everyone. It suits us, it suits the client and it suits the clearing broker. And it still leaves plenty of flexibility for the client to deploy plenty of excess cash and capital elsewhere.
Jared Gross: And I think as I've observed this in the market and I think you would probably agree with this as clients step out from cash and look for more productive ways to deploy that capital there’s a few kind of common stopping points. So, you know, many clients will look at keeping capital invested in fixed income but invest in a longer duration, slightly more credit sensitive portfolio that is designed to outperform the cost of financing those futures and as a way of generating excess return over the beta that you would have otherwise owned.
You'll see in some cases a strategy that is commonly referred to as portable alpha where the collateral is invested in a diversified fund of hedge funds where it’s a higher octane alpha generating engine that can be applied sort of to any level of beta or any beta target that’s available and liquid in the markets.
And in some cases they will take a piece of that capital and look for longer term opportunities in alternative asset classes where there may be less liquidity and so they have to be careful about the amount of money that they shift into those types of strategies but the return potential is significant enough that it is worth moving the money into that type of approach. So, you know, that’s a second leg of the discussion.
So maybe just to come back to the derivatives side one of things that comes up frequently in conversations around capital efficient investing and derivative usage is the distinctions between futures markets and swaps markets and there is a broad and fairly liquid market for total return swaps on a variety of benchmarks just as there is a liquid market for futures on a variety of benchmarks.
So Dan maybe spend a minute talking about the distinction between the two, you know, what are the actual differences between these two types of derivative contracts and which market sectors may be better positioned for one versus the other.
Daniel McNeill: Yes so the breadth of available derivatives in the market as you know is huge and essentially it can be boiled down to the level of customization or complexity of that derivative. So at one extreme there are the incredibly customized, very flexible futures markets around the world so those are contracts that are very standardized, they trade on exchange, they’re fully reported in terms of their volumes, they tend to be extremely tight in terms of the pricing with very many market counterparties for which to obtain liquidity.
Then as you go into slightly more bespoke arrangements then you’re starting to look at things like cleared swaps and then you look at bilateral or sometimes called uncleared swaps. And those are arrangements that you have with a individual broker or investment bank where some or all of the terms may be relatively standardized but there is to some extent a bilateral arrangement between you and the bank or the broker that you face.
So things like total return swaps which from an economic point of view maybe have identically to a futures market so they may still give you a positive exposure to the S&P 500 in exactly that $100 million amount that you wanted but they are actually an arrangement between you and the bank whereby the bank promises to pay you a positive return and you promise to pay the bank the negative return as opposed to you getting an exchange. And now those contracts may be very customized but you’re still being one to one with the bank.
So there’s some disadvantages in terms of a lack of overall transparency but there are many banks out there and you can look across the competitive market and you can make sure you’re getting good pricing but what you do get is a level of customization. So when you think about other benchmarks that clients may have so for example clients may re-benchmark to MSCI World or MSCI USA where there aren’t liquid futures markets then using the total returns swaps markets can be helpful because you can achieve a degree of customization.
Jared Gross: It sounds like as a general rule of thumb if there is a liquid futures market available because of the exchange clearing and counterparty risk management along with the standardization of the contracts and the transparency and the liquidity that that brings with it all else equal you would probably prefer a futures-based solution to a swaps-based solution.
But as you’ve noted there may be markets where a futures market is simply not very liquid or potentially not present at all in which case the beta if it is available through a total return swap would be advantageous and you just have to be a little more careful about how you approach the risk management.
But again all of those elements are something that a manager like JPMorgan can manage on the client’s behalf and fold into the structure and the liquidity management of the account itself is that fair?
Daniel McNeill: That’s absolutely right. The slight increased complexity in total return swaps you can offset by the increased flexibility that you can get and we typically work with clients, you know, upfront to say look here’s a menu of potential derivatives that we think we'll need for the outcome that we're looking for now let’s think about the implementation of those.
One item that I want to mention on swaps is because they are bilateral you have to go through certain negotiations with banks to make sure that your accounts are open and the client is onboarded for that bank and that’s something that we would do as a normal course of business onboarding our clients who wants to do derivatives. We would make sure that they had three to five banks set up using our documentation, standardized documentation with those banks on bringing the client or clients sort of up to speed for trading total return swaps.
And then the other thing just to mention is of course the changing regulatory landscape means that the regulators globally but certainly in the US are very keen to move away as much as possible from customized derivative contracts and move things closer and closer to either exchange traded or cleared. And clearing is just a form of exchange traded for certain types of derivatives contracts principally fixed income swaps. And that means that our time was on clients are getting the benefit of more and more standardization, more central liquidity frankly becomes easier for clients to implement derivatives.
Jared Gross: Well I think in the interest of time we'll begin wrapping this up just to kind of sum up what we've talked about today. One of the options that investors have to improve the performance of their portfolios is to activate inefficient capital by removing it from traditional markets, replacing that exposure with a synthetic beta in the form of a liquid transparent derivative contract and taking a portion of the capital that’s freed up and investing it for higher return elsewhere.
And although this sounds complex in some ways it’s actually well within the scope of an asset manager’s remit to engage in this activity on a client’s behalf and the benefits ultimately can be profound. And in a low return world like the one we're in capital efficiency is a pathway to better performance that investors should be aware of and should be very thoughtful about as it relates to particularly those segments of their portfolio passive equities, treasuries and other very liquid market exposures where they can achieve a better outcome.
So with that Dan thank you very much and we're going to wrap it up for today, take care.
Daniel McNeill: Thank you Jared.
Jared Gross: Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful you can find more episodes anywhere you listen to podcasts and on our Web site, thank you. Recorded on April 9, 2021.
Woman: For institutional, wholesale, professional clients and qualified investors only. Not for retail use or distribution. Not for retail distribution. This communication has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only as defined by local laws and regulation.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction nor is it a commitment from JPMorgan Asset Management or any of its subsidiary to participate in any of the transactions mentioned herein.
Any forecasts, figures, opinions or investment techniques and strategies set out or for information purposes only based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production.
This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine together with their own professional advisors if any investment mentioned herein is believed to be suitable to their personal goals.
Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks. The value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future result.
JPMorgan Asset Management is the brand for the Asset Management business of JPMorgan Chase & Co. and its affiliates worldwide. To the extent permitted by applicable law we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies.
Personal data will be collected, stored and processed by JPMorgan Asset Management in accordance with our privacy policies at https://am.jpmorgan.com/global/privacy.
This communication is issued by the following entities: In the United States, by JPMorgan Investment Management Inc. or JPMorgan Alternative Asset Management Inc., both regulated by the Securities and exchange Commission; in Latin America, for intended recipients’ use only, by local JPMorgan entities, as the case may be; in Canada, for institutional clients’ use only by JPMorgan Asset Management Canada Inc. which is a registered Portfolio Manager and Exempt Market Dealer in all Canadian provinces and territories except the Yukon and is also registered as an Investment Fund Manager in British Columbia, Ontario, Quebec and Newfoundland and Labrador. In the United Kingdom by JPMorgan Asset Management UK Limited which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions by JPMorgan Asset Management Europe S.A.R.L; in Asia Pacific, APAC by the following issuing entities and in the respective jurisdictions in which they are primarily regulated: JPMorgan Asset Management Asia Pacific Limited, or JPMorgan Funds Asia Limited, or JPMorgan Asset Management Real Assets Asia Limited, each of which is regulated by the Securities and Futures Commission of Hong Kong; JPMorgan Asset Management Singapore Limited Co. Reg. No. 197601586K, which this advertisement or publication has not been reviewed by the Monetary Authority of Singapore; JPMorgan Asset Management Taiwan Limited; JPMorgan Asset Management Japan Limited, which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency registration number Kanto Local Finance Bureau Financial Instruments Firm No. 330; in Australia, to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 Commonwealth, by JPMorgan Asset Management Australia Limited ABN 55143832080 AFSL 376919.
Copyright 2020 JPMorgan Chase & Co. All rights reserved.
LISTEN AND SUBSCRIBE