Risk premia strategies in all their various iterations have become immensely popular in the US as halfway houses between active and passive management. The market among conservative pension plans has hitherto been relatively muted, but last year one fund blazed a trail with an investment in a bespoke basket of risk premia strategies: the US pension plans of the Dow Chemical Company, which have roughly $15 billion of assets.
"When we first looked for some diversification away from directional strategies, we were interested in relative value basket on commodities and a range of other underlyings, taking advantage of mispricings by going long at certain points of the curve and short others. The idea was to get some diversification in our alpha generation on top of the existing investments that sit in our absolute return buckets," says Juan Troncoso, associate director for asset allocation at Dow Chemical US Pension Plans in Midland, Michigan.
The firm initiated discussions with several banks once it had made the strategic decision to make a sizable allocation to a range of smart beta strategies, eventually handing a mandate to Societe Generale to build a customised risk premia basket. There began roughly a year of conversations with the bank, as Dow sought to build exposure to an optimum range of strategies.
The final portfolio mix that was settled on by the fund included exposure to seven different asset classes: equity, equity volatility, commodities, rates, foreign exchange, foreign exchange volatility, and credit. Strategies included a relative value basket, a macro basket and a tail premium basket. The latter was composed of three income-generating strategies, designed to deliver high returns during bullish and bearish periods. Because of the higher risk of drawdown with this strategy, Societe Generale incorporated a risk-filtering algorithm with the aim of mitigating potential downside risk.
Dow deliberately sought out strategies that were entirely rules based. The weights of each strategy in the portfolio are rebalanced on a monthly basis to the target weight that was determined in the construction of the portfolio, with the weight of each strategy capped at up to 20% at the basket level for each counterparty.
At the end of the year, we will check our portfolio, and seek to eliminate strategies – and probably some counterparties, too. Efficiency is about costs as well as returns
"We designed the strategies with transparency and simplicity as our paramount concerns. We shared all of our pricing models with the client and all pricing parameters are external to Societe Generale, so they can run the strategies internally themselves. Beyond the investment platform, I think one of the reasons we won the trade was our ability to provide Dow with all the positions the investments track, in full transparency and on a daily basis, as if they were invested in the underlying assets," says Jerome Casamatta, director, cross-asset institutional sales for North America and Canada at Societe Generale Corporate & Investment Banking (SG CIB) in New York.
The provision of daily, granular data was considered vital by Dow from a risk management point of view, adds Casamatta, since it enables the fund to accurately capture its exposure to the securities underlying the risk premia strategies, and to check their concentration, sensitivity and overall fit with the rest of the fund's investments.
"We've had other pension funds calling us to find out about the strategy. They're asking us to share the experience of these kinds of investment," says Troncoso.
Dow gains its exposure to the strategies via a total return swap with SG CIB. The firm already had an International Swaps and Derivatives Association Master Agreement in place with the bank for routine trades, says Troncoso, which meant the fund - with a limited in-house back-office capacity - could keep post-trade costs to a minimum by seeking exposure in this manner.
"We have a single total return swap in place with SG CIB, which gives us exposure to the eight strategies. That's much more efficient for us in terms of the level of trade support required; we already had a credit support annex in place with them with market-standard terms that lets us post agency and Treasury bonds as collateral," says Troncoso.
Dow split its investment into three roughly even-sized tranches, which were executed over consecutive months in December, January and February. It has subsequently brought two other banks into the mandate.
"Partly, we are seeking diversification of counterparties, but we also wanted to see how different banks replicate and trade the strategies in live mode. We will continue to monitor the programme and make the proper adjustments at the strategy and counterparty level as needed to optimise the portfolio. Efficiency is about costs as well as returns," saysTroncoso.
So far, SG CIB has offered the best-quality service, he adds, thanks largely to its focus on cross-asset solutions; an approach Troncoso says differs from its peers.
"SG CIB has had an outstanding speed of response in the implementation phase as well as after trading the basket. The approach they have taken in consolidating multiple desks into a cross-asset solutions team means we have one point of contact to deal with on our risk premia strategies, no matter what the underlying is. That makes things a lot easier when you have an issue," he says.
The week on Risk.net, November 17–24, 2017Receive this by email