Wednesday, October 16, 2019

Investment Insights

Rebalancing through an overlay strategy during periods of volatility

By Jan Mowbray/Parametric

Periods of high volatility create opportunities for investors to add value through portfolio rebalancing, yet many institutional investors face challenges in implementing a portfolio-rebalancing strategy that provides for discipline and responsiveness during volatile markets. 

A lack of consolidated current portfolio values and onerous formal decision-making and approval processes—coupled with the decision of determining the right time to trade—often delay identifying and acting on rebalance triggers. Once approval is obtained, coordinating with many managers to buy and sell physical securities or funds can be time consuming and expensive. Responding in a timely and efficient manner to unanticipated market moves under this scenario can be very challenging. How to address this challenge? 

Potential solution

Rebalancing through an overlay introduces daily monitoring, real-time portfolio rebalancing, and the potential for reduced transaction costs—all while improving policy-benchmark tracking. Daily monitoring by the overlay manager allows for immediate identification of and response to portfolio imbalances. When rebalancing is necessary, the overlay manager brings asset classes back to the policy target by using long or short positions of exchange-traded futures, exchange-traded funds, and swaps rather than directing purchases and sales of the investor’s individual holdings. After portfolio imbalances exceed predetermined thresholds, the overlay manager buys policy-benchmark exposure to fill underweight classes and sells policy-benchmark exposure to reduce overweight classes, therefore bringing the entire portfolio back to policy in a disciplined, timely, and cost-effective manner. Using an overlay program to implement a disciplined rebalancing program reduces behavioral biases and forces the discipline of buying low and selling high.


  • Timely and efficient reallocation of portfolio exposure
  • Minimization of exposure gaps during the rebalancing process
  • Tracking-error reduction through policy-exposure management
  • Potential reduction in transaction costs compared with more traditional rebalancing


The United Kingdom’s vote to leave the European Union in June 2016 is a prime example of how short-term volatility can produce a rebalancing opportunity. This unexpected event, popularly known as Brexit, pushed equity prices sharply lower and caused bond prices to rise around the world. In
the two US trading days following the June 24 vote, the S&P 500 Index closed 5.3% lower (see figure 1). However, the drop in equity prices proved to be temporary, and in the following days and weeks the S&P 500 recovered all losses, rising further to establish new all-time highs. 

Click image to enlarge chart.

Given the short-term nature of the equity sell-off and subsequent recovery, rebalancing via traditional methods would have limited an investor’s ability to benefit from the temporary volatility created by Brexit. Institutional investors who use an overlay manager to rebalance their entire portfolio back to target allocations once pre-established trading bands are surpassed can capitalize on unexpected and often temporary volatility in the marketplace caused by events such as Brexit. 


Adopting a preapproved, disciplined rebalancing strategy through an overlay program allows investors to adjust exposure quickly and relatively cheaply in times of high volatility – without the need to move any physical assets in their portfolio. In addition, automatic rebalancing removes uncertainty and behavioral implications that can lead to inaction or the wrong action. Reacting to market volatility with a focus on controlling policy-based risk often produces meaningful amounts of incremental return. Declining markets may continue to decline, of course. However, rebalancing is a policy-based exercise that tends to add return over multiple market cycles.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Parametric or TEXPERS, and are subject to revision over time. 

About the Author:
Jan Mowbray is responsible for designing, trading and managing overlay portfolios at Parametric. 

Investment Insights

Looking under the hood: 

The essentials of fund-level leverage

By Neil Rudd/NXT Capital

Investors considering a new fund investigate its risk and return characteristics, the manager’s track record, deal sourcing and underwriting process, and reporting and controls. For levered funds, investors also evaluate the nature, use and terms of the fund-level financing. Or do they?

When it comes to levered funds, these factors take a back seat to the maximum leverage outlined in the placement memo. Considering this “sticker” leverage is one important measure of risk, but not the whole story. Fund leverage deserves a closer “look under the hood.”

There are various forms of fund-level leverage and no single right way to use them. Each approach offers benefits, but also has potential risks that investors should understand. A few key questions can reveal the manager’s leverage strategy and ability to protect investors’ interests.

The Basics

There are two primary forms of fund-level leverage: Asset-backed credit facilities and subscription facilities. Each is secured by different collateral and is often used for different purposes. Today, a levered fund is likely to include long-term subscription and asset-backed facilities.

Asset-Backed Credit Facilities

Asset-backed credit facilities are secured by a fund’s loans. Borrowing availability increases over time, in lockstep with the size of the loan portfolio.

There are two common types of asset-backed credit facilities with some important differences:

1. Approval Rights
2. Non-Approval Rights

Click image to enlarge chart.

Subscription Facilities

Subscription facilities are secured by the fund’s equity capital commitments and are generally used during the ramping period of the portfolio. Subscription facilities are typically less expensive than asset-backed credit facilities. Once the loan pool has been built, the loans are often rolled into an asset-backed facility.

Click image to enlarge chart.

Understanding A Fund’s Leverage Strategy

Fund-level leverage facilities can seem complex, but by asking a few of the right questions, investors can quickly come to grips with the most important elements.

  • What fund level leverage is going be used?
  • What is the Agent’s history? If more than one lender is required, what is the syndication strategy?
  • What systems and controls are in place to fulfill compliance, reporting and other requirements?
  • A six-year fund life in not uncommon, but most banks will not provide a credit facility for more than five years. What is the strategy to avoid hitting a maturity wall?

Look Under the Hood

Each form of fund-level leverage offers benefits and potential risks. Asking questions about a manager’s leverage strategy and ability to execute it effectively should become a standard part of investor due diligence. “Looking under the hood” to understand fund-level leverage is a prudent step in making fully informed decisions about levered funds and their potential returns.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of NXT Capital or TEXPERS, and are subject to revision over time. 

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Investment Insights

Six themes to guide investors the next five years

Trade conflicts, slow growth and politics among the most likely to rattle markets

By Jim McDonald/
Northern Trust 

Recent strong risk asset returns, paired with sharply lower global interest rates, represent an atypical investing environment. Investors have been working through a mash-up of slowing growth, muted inflation and easier monetary/regulatory policy — all wrapped in rising political uncertainty and on-again/off-again trade tensions. Against this backdrop, six key themes have emerged for our five-year outlook

#1 Global Growth Restructuring

The global economy must evolve as political and technological developments spur the world to step back from a more optimal framework for global trade.

What this means for investors: Slow economic growth and the risk of recession will accompany this restructuring, although eventually the global economy will emerge stronger and better suited to this new world. Growth is likely to be slower over the next five years than the past five years (Exhibit 1). Market volatility is likely to increase in response to negative economic data. Investors should prepare for equity returns below long-term historical averages.

Click image to enlarge chart.

#2 Irreconcilable Differences

Conflict between the U.S. and China — a focal point of Global Growth Restructuring — will produce a cascade of political, economic and market changes.

What this means for investors: As the two countries zigzag between economic armistice and war, never achieving peace, market volatility is likely to spike. Investors need to be aware of whether other countries align with the U.S. or with China.

For more on investment themes, download the full paper.

#3 Stuckflation 4.0

Muted growth in global demand and timid policy responses suggest Stuckflation — now a theme for four consecutive years — is here to stay. Most major central banks continue to miss their 2% inflation targets (Exhibit 2).

What this means for investors: Low interest rates and flat yield curves will continue to make it difficult to find investments with attractive yields. We anticipate that disappointment with inflation rates will eventually lead to a coordinated policy response.

Click image to enlarge chart.

#4 Executive Power Play

Populist leaders are grabbing political power in exchange for pro-growth policies that have supported the long-running equity bull market. Looking ahead, leaders are at risk of overplaying their hands.

What this means for investors: Voter enthusiasm for these leaders may decline once economic growth slows, and investors should be ready for market volatility. Truly strong leaders will balance the populist movement with sensible economic policy. The risk is that they don’t devote enough energy to good economic policy.

#5 Monetary Makeover

The persistently low inflation that accompanies Stuckflation has stripped central bankers of their purpose.

What this means for investors: Central banks will reluctantly take unprecedented moves. Still, investors can’t look to central banks to boost inflation and global economic demand. This task is the responsibility of fiscal and broader economic policy — controlled by politicians. As a result, economies and investors may be more vulnerable to political developments.

#6 Staking Out Climate Risk

The impact of climate risk regulation will build slowly and sporadically as the world tries to reconcile growing carbon emissions with Paris Agreement commitments.

What this means for investors: Investment categories with direct exposure to transition risk — created by higher fuel standards, updated building codes, and clean energy and other requirements — require special attention. However, these risks will vary greatly by country, and transition risk can be reversed when confronted by political backlash. In some cases, this already has happened. Investors should consider industry risk on a country-specific basis.

Sound Like Fun?

So low growth, low yields and political volatility. It might not sound like fun to be an investor over the next five years. But we always confront uncertainty even in the best of times. As we see it now, positive breakthrough prospects are evenly matched with dire scenarios. Our outlook falls in between, which should result in decent risk asset performance and subdued fixed income returns during the next five years.

Learn More from Jim McDonald

Watch the replay of the webinar The Next 5 Years: What Investors Can Expect, featuring Jim and Chief Investment Officer Bob Browne, CFA.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Northern Trust or TEXPERS, and are subject to revision over time. 

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Investment Insights

Are BBB-rated credit fears real or overblown?

By Wayne A. Anglace, Michael G. Wildstein & William E. Stitzer/Macquarie Group

The amount of debt in BBB-rated bonds – the lowest rung of investment grade categories – has risen substantially in recent years, now comprising 51% of the investment grade universe, up from 33% in 2010 (source: Bloomberg and Macquarie Investment Management). This development has captured investors’ attention, sparking fears that the growing number of BBB-rated companies, vulnerable to economic stress, could potentially lead to widespread downgrades to the high yield, or “junk,” bucket.

Despite these concerns, we favor being overweight in BBB-rated credit, believing that valuations in this ratings category are more attractive than higher-quality A-rated debt, perhaps due to these broad downgrade fears. The large and diverse BBB-rated part of the credit market we believe provides potential opportunities to invest in resilient credit stories that could reward investors through strong fundamental credit research and careful security selection, even during periods of economic stress.

We see several market factors that argue for remaining solidly invested in the BBB-rated credit portion of the investment grade market. These include the BBB category’s relatively wide disparities, such as differences in potential downgrade rates that can help serve as a rating “cushion.” Also, highly levered bonds with a mid-BBB or BBB- rating often have less room to avoid downgrades and we would suggest that these issuers have more incentive adhere to deleveraging plans and remain investment grade, whereas A-rated issuers may be more willing to take on leverage and sacrifice their ratings while still remaining investment grade. 

A rating “cushion” in BBB

The disparity of credit quality across the full BBB-rated market is notable. Approximately 75% of the BBB-rated market is either mid-BBB or BBB+, with only a small portion (25%) rated the riskier BBB-, the last rung on the investment grade ladder before falling to high yield (source: Bloomberg). We think it’s worth noting that three-quarters of the BBB market (BBB+ and BBB), which the press has written so much about recently, has one to two rating notches of cushion before being considered a “fallen angel” or dropping from investment grade. As the chart below shows, the mid-BBB and BBB+ categories combined have increased in recent years (as a percentage of the overall BBB ratings category), effectively expanding this relative ratings cushion to high yield, with the BBB- segment holding relatively steady and slightly shrinking since 2015 (sources: Bloomberg and Macquarie Investment Management).

The BBB market by ratings category

Click image to enlarge chart.

Higher ratings don’t necessarily mean safer

We see another important consideration at the lower end of the investment grade market, in that moving up in credit quality may not necessarily insulate investors from future losses due to ratings downgrades. Companies that are A-rated typically are larger and better capitalized than lower-rated peers – characteristics that could be seen as dry powder for shareholder-friendly activities, which could cause a ratings downgrade (while still maintaining a lower-investment-grade rating). Such events could lead to unexpected volatility in A-rated issues which often times are deemed “safer” by investors, simply due to a higher credit rating than that of a BBB-rated issue.

In a world of low interest rates (that is, low corporate borrowing costs), A-rated companies may be incentivized to reward shareholders and sacrifice their A-ratings. In some cases, this can make A-rated issuers that get downgraded to BBB a surprise to investors, in our view. In the graphic below, we show examples of A-rated companies that were downgraded, and the resulting effects before and after the downgrades. 

Effects of downgrading from A to BBB

Click image to enlarge chart.

Note: “A” index refers to the A-rated component of the Bloomberg Barclays US Corporate Investment Grade Index. Table shown is for illustrative purposes only. 

Looking past the headlines

As risk-aware investors in this shifting market environment, we believe it’s important to look past the headlines surrounding the BBB-rated market, and identify securities in this category that potentially offer more opportunity than even higher rated ones – but with research-based, careful credit selection as the key.

Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Fixed income may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.

High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds. Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Bond credit ratings published by nationally recognized statistical rating organizations (NRSROs) Standard & Poor’s, Moody’s Investors Service, and Fitch, Inc. For securities rated by an NRSRO other than S&P, the rating is converted to the equivalent S&P credit rating. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.

Note: All charts are for illustrative purposes only. Charts have been prepared by Macquarie unless otherwise noted. 
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Macquarie or TEXPERS, and are subject to revision over time. 

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Investment Insights

Downside analysis of the S&P 500 Index

By Mark Shore/Coquest Advisors

Since the financial crisis, the U.S equity markets appreciated from their 2009 lows, making new highs with a few corrections along the way. However, as the markets experienced increased volatility recently, and economists talk of a late economic cycle, this seemed to be an appropriate opportunity to examine the downside of the equity markets.

This study focuses on the S&P 500 index (SPX) negative quarters since 1980 and the behavior of managed futures (CTAs) and real estate (REITs). Did they offer any downside protection during those negative quarters?

In recent years, managed futures returns, in the aggregate, have been challenging. The BarclayHedge CTA index contains several hundred funds representing various managed futures styles. However, trend-following systematic funds are the majority of the managed futures industry. 

Background Statistics:

There are 158 calendar quarters from January 1980 to June 2019. The SPX was negative 50 quarters or roughly 32% of the time. What does equity behavior look like in that 1/3 time frame?

Figure 1: The five largest negative SPX quarters from January 1980 to June 2019

Click image to enlarge chart.

Source: Bloomberg data. Indexes include S&P 500 Index, FTSE REIT Index, BarclayHedge CTA Index.

Figure 1 demonstrates three items: 1) during the top 5 largest equity quarter declines, REITs were also negative, while managed futures experienced positive returns. 2) REITs outperformed SPX in three of the five quarters. Managed Futures outperformed SPX by a wide margin in each quarter. 3) The five largest SPX quarterly drawdowns occurred in the 3rd and 4th quarters of their respective years, which begs the question, are SPX quarterly drawdowns induced by seasonality? I’ll address this question in a future article.

The correlation matrix in Figure 2 points out CTAs are non-correlated to both benchmarks. See February article for rolling correlations. What about negative quarter correlations? Figure 3 illustrates managed futures becomes more negatively correlated to both indices during environments of stress, supporting the results in Figure 1.


Figure 2: Correlations for all 158 quarters

Click image to enlarge chart.
Source: Bloomberg data. Indexes include S&P 500 Index, FTSE REIT Index, BarclayHedge CTA Index.

Figure 3: Correlations when SPX quarters were negative

Add caption

Source: Bloomberg data. Indexes include S&P 500 Index, FTSE REIT Index, BarclayHedge CTA Index.

Figure 4: Negative SPX quarters Jan 1980 to June 2019.
Click image to enlarge chart.
Source: Bloomberg data. Indexes include S&P 500 Index, FTSE REIT Index, BarclayHedge CTA Index.

Several items to note in figure 4:

1) Managed futures has a positive average return during the 50 SPX negative quarters.

2) The maximum difference between SPX and REITs was 17.04% in Q2, 2002 when SPX declined 13.7%, and REITS appreciated 3.3%. The same quarter managed futures increased by 8.2%.

3) The maximum difference between SPX and CTAs was 42.3% in Q1, 1980 when SPX = -5.4% and CTAs increased by 36.9%. REITs = -6.62% in that quarter.

4) Managed futures outperformed SPX 82% of the time and outperformed REITs 72% of the quarters.

5) REITs are negative 66% of the quarters. The average negative REIT quarter = -8.26% has more potential tail risk than SPX. The Managed futures index is negative 21% of the time with an average negative quarter of -2.62% and the worst quarter at -8.7% that occurred in Q1, 1992. During that quarter SPX = -3.2% and REITs = -1.2%. 

Figure 5: CTA returns relative to SPX, and REIT returns relative to SPX
Click image to enlarge chart.
Source: Bloomberg data. Indexes include S&P 500 Index, FTSE REIT Index, BarclayHedge CTA Index.

Figure 5 shows, in most cases, both REITs and managed futures outperformed equities during the negative SPX quarters. Managed futures underperformed SPX in the single digits, but did not go below -8.7% and REITs in more recent quarters on a few occasions underperformed by a wider margin.


No one knows when the next equity market decline or economic contraction will occur. An investor knowing their choices to reduce downside risk may offer assistance in the long-run.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Coquest Advisors or TEXPERS, and are subject to revision over time. 

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Investment Insights

The OCIO model: How to measure success 

By Angel Haddad/Callan

The outsourced chief investment officer (OCIO) industry has grown significantly over the last 10 years. Low barriers to entry have contributed to a proliferation of providers, from boutique firms to larger investment management and investment consulting organizations. Given this growth, institutional investors will need to be prudent in evaluating the changing dynamics of this space.

According to Cerulli Associates and Plansponsor, defined benefit plans and nonprofits with $250 million or less in assets represent the largest client base for OCIO services. Institutional investors with limited internal resources are particularly attracted to this model, as some do not have the capability to handle the complexities of less liquid and less transparent investments that may be necessary to achieve desired return objectives.

One of the key questions for evaluating the performance of the OCIO community is: How do we measure success? I recently wrote a comprehensive paper on the subject, and wanted to share in this article several fundamental factors that successful institutional programs should embrace: 

  • Keep the Best Interest of the Fund and Its Beneficiaries in Mind: This is a fundamental principle in supporting the investment needs of clients. This is particularly important for OCIO mandates given their custom nature and the need to manage multiple variables to enhance the potential for competitive performance.
  • Open Architecture Platforms: In our experience, open architecture platforms with best-in-class products at competitive fees offer a better opportunity for implementing best-in-class mandates, as no investment manager is proficient in every asset class it offers. Furthermore, model portfolios may not meet the needs of every client. This approach also helps eliminate potential conflicts of interest inherent in a proprietary fund framework.
  • Power of Simplicity: We believe in keeping investment structures relatively simple, without needing to sacrifice sophistication or diversification opportunities. In some cases, as assets grow, investment structures become more complex to take advantage of specialized strategies. Even in these circumstances, we believe in reducing complexities and introducing efficiencies in implementing a sound manager structure.
  • Monitoring Agency Risk: Here are some of the common agency risks we believe need to be monitored closely:
    • Fees: Underlying product fees may be higher for some OCIOs compared to alternatives. Fee negotiations should create value for the exclusive benefit of the client. Fee transparency is also very important. The fund sponsor needs to be aware of the fee structure to ensure that common interests are aligned appropriately. 
    • Tactical Approaches: OCIO service providers usually command a premium for tactical positioning to take advantage of short-term market anomalies for alpha generation. However, in our experience, managers have had limited success creating value consistently using this approach. This raises the question of the manager’s value proposition regarding a tactical approach. If the client is paying for tactical asset allocation, the OCIO should take advantage of these market dislocations for alpha generation. Otherwise, why should the client pay these fees? We believe fee structures need to be aligned with the best interests of the client in mind. 
    • Manager Selection: The quality of the OCIO’s manager selection process has implications for the client, mainly in terms of performance, manager turnover, frictional costs, and the potential for conflicts of interest. OCIO providers need to have a well-documented manager search process that supports quality, operational efficiencies, value creation, and operational continuity to help identify long-lasting product solutions for clients. The process needs to avoid a manager-selection process driven by any economic interests between the OCIO and other third parties and needs to focus on identifying the best possible product solution for the mandate in question.
  • Managing Client Expectations: We believe it is important to set realistic expectations with clients to make sure they understand the full range of services offered by the OCIO and its limitations. There is a fine line between employing aggressive sales practices in pursuit of new business and setting the right expectations with clients and prospects. This dynamic may tempt some service providers to over-promise and under-deliver, impacting the quality of their services and contributing to a situation that may not be sustainable or tolerated by clients.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Callan or TEXPERS, and are subject to revision over time. 

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Investment Insights

CEO sea change on shareholder primacy: Good economics or decreased accountability?

By Hannah Ross and Lauren Cruz/BLB&G

The Business Roundtable announced that it was officially abandoning its long-held belief in the so-called “shareholder primacy” theory of corporate governance.

On Aug. 19, the Business Roundtable, which includes the CEOs of 181 American companies (including Walmart, JP Morgan, and AT&T), announced that it was officially abandoning its long-held belief in the so-called “shareholder primacy” theory of corporate governance. Instead, the Roundtable “moderniz[ed] its principles on the role of a corporation,” propounding the idea that corporations should operate for the benefit of all stakeholders, including customers, employees, suppliers, communities, and shareholders. 

The Roundtable’s revised statement is intended to serve as “one element of Business Roundtable’s work to ensure more inclusive prosperity” in America after decades of deepening economic inequality. The group also called on leading investors “to support companies that build long-term value by investing in their employees and communities.”

While some commentators have responded positively to the Roundtable’s announcement, many investor groups fear that this change will encourage companies to obfuscate shareholder rights and mask poor management with seemingly good intentions. The Council of Institutional Investors, comprised of entities with more than $4 trillion in combined assets under management, stated that this change “undercuts notions of managerial accountability to shareholders” while proposing no “new mechanism to create board and management accountability to any other stakeholder group.” Thus, a new focus on “stakeholder governance” could create “hiding places for poor management” that would undermine the efficiency of the US equity markets and “the economy more generally,” the Council added. Moreover, many have noted that under state law, companies still owe a fiduciary duty to shareholders only and thus shareholder primacy is still the law — a law which the proposed policy change might violate.

Time will tell whether American companies indeed adopt this new operational focus for the benefit of all stakeholders and, if so, whether it would be consistent with various state laws. We will keep our readers updated as this story develops.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of BLB&G or TEXPERS, and are subject to revision over time. 

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