Ask most asset owners what they want from their managers and their mantra is often good returns, low and transparent fees and alignment. But one seam that runs through the most successful and enduring manager-owner relationships has nothing to do with headlines fees or skin in the game. The bedrock to one of the State of Wisconsin Investment Board’s (SWIB) most important relationships has been the pension fund’s ability to call on its manager’s knowledge and expertise since setting up a ground-breaking risk parity approach using derivatives and leverage seven years ago.
Today SWIB applies leverage to around 10 per cent of its $110 billion portfolio across different asset types using various instruments in internally and externally managed strategies.
Five per cent of that comes from a levered TIPS exposure run by Seattle-based Parametric Portfolio Associates’ whereby SWIB borrows money in the repo market using TIPS as security to access cheap, stable sources of finance.
Over the years the strategy has successfully reduced equity and liquidity risk and positioned the fund for rising inflation, just as it was designed by SWIB. Yet rather than consigning its relationship with Parametric to a basic understanding of how they run the mandate and regular check-ins that it’s performing as expected, SWIB has forged a deep, educational exchange.
“We ask a lot of questions,” says Chris Benish (pictured below) asset and risk allocation managing analyst at SWIB.
The result is that SWIB, world-renowned for its large in-house team and expertise, has learnt to run levered strategies itself.
Under Parametric’s tutorage the fund has grown comfortable understanding the instruments involved and all the moving pieces to manage a chunk of the total levered allocation in-house – to the extent that most of its leverage is now sourced through internally managed strategies rather than external managers.
“Some of those additional strategies that were part of the Parametric relationship initially, due in part to knowledge sharing with Parametric and taking that journey with them, have been internalised,” says Benish.
Moreover, when SWIB first started exploring how it would use leverage it wanted to apply it across domestic equity and commodities, as well as domestic fixed income. Weighing up the pros and cons involved a lengthy collaboration between the two partners several years prior to the strategy launch in 2012 to determine how much leverage SWIB could comfortably hold, and the boundaries around leverage it should put in place.
“We worked hard before the launch,” recalls Chris Haskamp (pictured above) portfolio manager at Parametric for the last 13 years and who was involved in these early processes. Only as it turned out, some of the other asset classes dropped out and the focus switched, in the main, to TIPS.
Far from the relationship waning as the mandate was scaled back from its original ambitions and SWIB did more itself, it has gone from strength to strength. The reason is because much of Parametric’s business is client education.
“It’s a big part of our job,” says Haskamp. Even so, SWIB’s sophisticated and large internal team has led to a different type of conversation and thirst for know-how that sets the relationship apart from many of Parametric’s other clients, especially those with smaller teams or thinly staffed.
Witness how Parametric is currently advising SWIB on how best to add swaps to access a levered TIPS exposure, analysing how swaps would potentially work in the portfolio, their different operational considerations to repos and the availability of viable counterparties.
“Our job is to educate on costs and how swaps would behave before SWIB jumped headfirst into putting these positions in place,” says Haskamp who makes light work of all the intricates involved. “We trade swaps across our client base extensively and it’s something we’re very familiar with. We’re equipped to handle the complexity of getting initial account documents in place, and then valuing, trading and maintaining those positions over time.”
Flexibility
The introduction of swaps also illustrates how the relationship is defined by flexibility: Parametric’s ability to adapt as SWIB’s strategy evolves is fundamental to its success. When SWIB and Parametric initially developed the allocation, they found the cost of financing via swaps was higher than going the traditional repo route and opted for the latter.
Today that’s no longer the case. “Our counterparties have indicated that from a balance sheet perspective the cost of putting on a swap compares to, and is in some cases cheaper than, what they can offer from a repo perspective,” explains Benish. “Early indications are that we can do swaps more cost effectively than what we have been able to do historically because of changes in the cost of funding.”
And Haskamp is more than ready to help. “Building in the capability of doing swaps when the costs are similar could be beneficial,” he says.
A recent decision to extend the tenor on some of the short-term repos to better counter liquidity risk is another example of this flexibility in action. “It costs a little more, but when we looked at our overall liquidity risk it made sense,” says Benish.
Elsewhere, SWIB recently called on Parametric to help navigate adding repo through a central counterparty for the first time in a departure from its usual bilateral counterparty relationships.
“It was fairly novel and although everything ended up working similar to what we were familiar with, there were a few wrinkles in terms of the legal agreements and some of the set up,” says Benish.
Adding centrally cleared repo in amongst other initiatives to diversify counterparty sources is perhaps the best illustration of how flexibility and creativity has played out. In this case helping dig the strategy out of a dangerous hole in its early years. In 2012 repo counterparties like commercial banks, dealers and brokers, sitting in the middle of the market and prepared to provide balance sheet, were still commonplace. Not so as the impact of the financial crisis rippled out and many counterparties pulled back, leaving SWIB struggling to hold onto the levered positions it needed. “Balance sheet got a lot more expensive and counterparties become less interested in extending repo capacity to us, and in some cases reduced that repo capacity,” recalls Benish.
Cue a new, creative approach to source capacity in the repo market. In a highly collaborative process, Parametric and SWIB brainstormed ideas and looked under new rocks for new sources of leverage that has led to today’s cohort of non-traditional counterparties with different credit profiles like securities lending reinvestment pools, other pension funds (including the State Investment Fund, a pool of cash balances of the Wisconsin Retirement System comprising various state and local government units managed by SWIB) and centrally cleared repo. “We are at the point now where we have a good stable of capacity we can tap if we need to,” says Benish.
Low costs
Education and knowledge transfer is one pillar. The other key part of the relationship rests on Parametric ensuring SWIB can access the cheapest possible source of leverage through its implementation and tailoring of exposures in the mandate it runs.
“These are the things that if you don’t pay attention, can eat into expected returns over time,” says Haskamp.
Designed to earn a TIPS index return, the strategy doesn’t seek to create alpha or beat a benchmark and Parametric hasn’t designed anything bespoke for SWIB. “We’ve been doing this for decades. There is nothing unique about the strategy other than perhaps the scale,” says Haskamp. And low costs include low fees. The passive strategy means SWIB doesn’t pay Parametric a performance fee and other fees are based on the exposure the manager provides. “The fee structure is simple. As the assets we manage grow or contract, it adjusts the fee up or down,” says Haskamp, explaining how Parametric is on hand to add and reallocate from the strategy as SWIB’s needs change from a leverage and policy allocation standpoint. Over the years, SWIB has added more fund-level leverage either from TIPS or from the other levered strategies run in-house in response to different market conditions, and the strategy growing over time. The pension fund anticipates an asset allocation that includes 20 per cent leverage in the longer-term.
Benish and Haskamp estimate they speak about once a month in a conversation that will touch on cash flows and rebalancing, what Parametric sees in the funding market versus what SWIB sees, or maybe the viability of a new counterparty. The holdings and allocations in the portfolio are highly transparent, liquid securities and adjustments on the fly is a fairly easy process. Nor is the leverage expensive and it’s relatively easy to come by – now. Yet even when it’s all going to plan a regular touch base is important to ensure they are on the same holistic, and tactical, page.
Benish says he takes a holistic view of the fund’s leveraged position, the levered asset mix and the kind of risk profile, especially around liquidity, SWIB wants the leverage to have in a top-of-the-house view. Meanwhile Parametric gets into the weeds. This could include a close analysis of specific bonds or farming out line-items to counterparties to get the leverage just right. And, of course, the day-to-day management of the mandate from margining all the leverage positions, to rolling repo positions on a monthly basis when the US Treasury issues new TIPS. “It does involve a fair amount of man hours in the back and middle office process,” says Haskamp. Pausing before he concludes: “But education is a much bigger part of the relationship than actual trading.”
