# MSIM’s baffling $400m options splurge ## Funds owned or advised by the manager have spent vast sums on a USD/CNH strategy that appears not to have paid off At first glance, the Growth Portfolio mutual fund offered by Morgan Stanley Investment Management seems fairly straightforward, holding a selection of tech-heavy US stocks like Cloudflare, Doordash and Snowflake. But over the past five years, the nearly$10 billion-asset fund has also spent $150 million on something seemingly unrelated – a string of options to buy US dollar against the renminbi, which would only pay off if the Chinese currency collapsed in value. It’s not an isolated strategy. The fund is managed by MSIM’s Counterpoint Global team, headed by portfolio manager Dennis Lynch. Regulatory filings show the team has used this strategy across at least three MSIM funds and another three funds where the manager acts as a sub-advisor responsible for trading strategy. The funds held a combined$37.7 billion of assets at the end of last year.

In total, those six funds owned or advised by MSIM paid more than $400 million in premiums for US dollar/renminbi options over the last five years, for a total position of$79.5 billion notional – with half of that spend occurring in the past year as position sizes ramped up. But spot never got near the strikes on these positions, and it’s assumed the vast majority of that premium was lost.

The options are the only foreign exchange derivatives instrument used in the funds examined. It is unclear whether the positions are a way to hedge China risk in the equities, a macro hedge against wider market movements, or a straight-out punt. MSIM declined to comment.

Nevertheless, it’s a strategy that has surprised some in the market. “It’s not obvious to me what they would be hedging,” says a trader at one US hedge fund. “But $150 million premiums is pretty massive,” he says, referring to premiums paid by the manager's Growth Fund portfolio for positions on the books from 2020. Gerry Fowler, a portfolio manager in the multi-asset solutions team at Abrdn, says the positions may have made some sense in the past year when the prospect of rising US rates threatened to undermine the low yields that have supported high equity valuations. USD/CNH options could allow equity managers to realise some upside from this risk, given the contrast between monetary tightening in the US and loosening in China. Prior to that, the trades could have been an expression of China-US trade war concerns and a way to hedge in case tensions escalated. ### Premium outlay With premiums totalling$22.8 million on average each quarter, the manager maintained $12.2 billion of average notional positions across the six funds examined since late 2017, with average tenors of less than a year. However, total notionals, trade sizes and the cost of building those positions grew steadily over that time, with the manager spending more than$80 million in premiums in the third quarter of 2021 alone across the six funds.

At the end of Q4 2021, the manager held $40.5 billion notional of USD/CNH options across the six funds. These positions represent five times the total FX options notional – across all currencies – held by its nearest peer, Invesco. The call option positions were all struck on average 15% out of the money and would pay out if spot moved significantly upwards, but it never rose enough to cross the strikes in nearly five years of running the strategy. In the first quarter of 2021, for instance, MSIM’s Growth Portfolio fund listed a$3.3 billion USD/CNH call option with a strike of 7.57 and expiry on March 30, 2022. Spot at the end of the first quarter rested at 6.57, meaning the rate would have had to move 15% higher over the year for the option to expire in the money. The most the rate has moved upwards in a year since 2011 was 8.2%, in the 12 months up to June 2019.

Instead, as spot remained below the strike price, the fund continued to mark down the value of its position, from $12.7 million in the first quarter to$162,000 in the fourth, according to quarterly filings. Spot finished at 6.36 and the option expired worthless, a likely net loss of $16.4 million in premium. The scenario mirrors MSIM’s other USD/CNH positions, where call options struck far out of the money declined in value before expiring. It’s not clear from the filings whether the fund traded out of its position, possibly recouping some premium, or allowed the options to expire. Over time, the Growth Portfolio held increasingly larger bets on a rising spot price, both in notional terms and according to their own mark-to-market valuations. The largest single position in the history of the trades came last quarter – a reported$4.2 billion call option expiring in November with a 7.27 strike. MSIM paid Goldman Sachs $20.2 million for the option, which the fund valued at$12.7 million. As of late April, spot remained well below the 7.27 strike.

For the average position to finish in the money, spot would have had to move 15% higher between the trade first appearing on the funds’ books and its expiry date, typically less than a year later. But realised volatility has been significantly lower in recent years, with three-month movements hitting 7% at their peak in 2018 and then averaging 4% since the start of 2020, according to Bloomberg data.

NatWest Markets was the counterparty for 34% of the notional, taking in $137 million in premiums since late 2017, though the bank no longer holds any positions with MSIM. BNP Paribas, JP Morgan and Goldman Sachs held the rest, netting$114 million, $87 million and$73 million in premiums, respectively. The four dealers declined to comment.

In Q4 2021 – the most recent data available in Risk.net’s Counterparty Radar tool – JP Morgan was counterparty to $16.4 billion notional for the USD/CNH options on the six funds’ books, while Goldman Sachs held$15.8 billion and BNP Paribas $8.3 billion. Dealers’ profits on the trades is hard to work out exactly, but was likely sizeable. Take the$3.3 billion call option struck with Goldman Sachs at 7.57, which had a premium of $16.38 million according to fund filings. It expired on the March 30 this year, and was struck in the first quarter of 2021 – for this example, it is assumed it was struck on March 30, 2021. Analysis by Uwe Wystup, founder of FX options consultancy MathFinance, found this trade alone would have allowed Goldman Sachs to book a day-one profit of more than$2 million, based on the difference between the mid-market value at the time and the premium paid.

There are some caveats, though. First, this doesn’t take into account possible hedging costs. Second, while data was sourced from Eikon and Ice Data Services for the analysis, it also may not match the quotations from Goldman at the time. And third, it isn't clear at what time the trade was executed.

The prospectus for Morgan Stanley’s Growth Portfolio gives little clue as to the thinking behind the options trades but explains the manager has a wide latitude to trade FX options.

“Foreign currency options contracts may be used for hedging purposes or non-hedging purposes in pursuing a fund’s investment objective, such as when the adviser anticipates that particular non-US currencies will appreciate or depreciate in value, even though securities denominated in those currencies are not then held in the fund’s investment portfolio,” the prospectus reads.

Brighthouse and Transamerica both give MSIM wide discretion to allocate assets and trade for the funds MSIM sub-advises. The dynamic may explain why, in addition to holding nearly identical USD/CNH option positions, the three sub-advised funds examined show that trades were executed with the same set of dealers MSIM used on its own funds for those same positions.

An FX head at a large asset manager says the positions effectively represent a bet that at some point Chinese authorities will allow the currency to lose value.

“I would have thought just passively buying out-of-the-money calls is probably a losing strategy – unless it is some kind of lottery ticket on the risk of China devaluing,” says the currency head.

Abrdn’s Fowler sees some logic behind the strategy, even if the reasoning behind the exact positions was not obvious.

“I’m not entirely sure why they were choosing CNH, specifically, instead of a mix of other currencies that probably would have been equally as weak versus the dollar in the current circumstances. But I suspect they took a general view that they can get protection from rising yields through out-of-the-money currency options,” he says.

The average quarterly cost to the Growth Portfolio, specifically, was $30.8 million for the three quarters it showed new positions last year, less than 1% of the fund’s assets over that period. “Over the last decade, most investors have been pretty reluctant to spend anything on protection. But if you’re spending well under 1% of the portfolio on an annual basis on protection – particularly on a fairly high-beta and, at least for the last decade, high-returning portfolio – that’s pretty low cost,” says Fowler. MSIM’s Counterpoint Global funds have consistently delivered high returns, earning high marks in the Wall Street Journal’s Winners’ Circle contest, which compares 12-month returns from actively managed US equity funds. How much drag the options strategy puts on the portfolios is unclear. “Our strategy has been to collect a portfolio of unique companies that have a strong competitive position and offer big growth opportunities over the long term. We don’t try to make any shorter-term predictions,” Dennis Lynch told the paper in 2020. Lynch joined Morgan Stanley in 1998 and currently serves as the lead manager for nine of Counterpoint Global’s funds. He says he and the team take personality tests every couple years “to promote a little self-awareness and good communication”. But the team’s funds have struggled recently. With$8.8 billion in assets under management in late April, the Growth Portfolio has lost over half its value from its November peak. Still, the fund’s annual return has averaged 17.5% over the past decade. The Discovery and Insight portfolios have followed similar trajectories.

Additional reporting by Joe Parsons and Lukas Becker

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