Charles Darwin might have been famous for such works as On the origin of species, but he also dabbled in the stock market. In the 1840s, investors such as Darwin piled money into the great investment bubble of the nineteenth century - the British railways - and many ended up losing vast amounts of wealth as the stock index plummeted from highs of 160 points in 1845 to 60 points just five years later.
"There's a price for everything, and it got too high," says Robert Shiller, a Nobel Prize winner and creator of the cyclically adjusted price-earnings (Cape) ratio, which tries to forecast future returns in equities based on historic value.
Shiller believes in mean reversion: the price of any stock will eventually come back in line with previous inflation-adjusted average earnings over a 10-year period. Using the Cape ratio, Darwin would have discovered that railroad stocks had become significantly overvalued.
While the Cape ratio itself is not a new concept - Shiller came up with the idea in 1981 - Barclays launched the first index based on the idea, known as the Shiller Barclays Cape US Sector index, in 2012. Three years later, fixed-income asset manager DoubleLine Capital - the Structured Products institutional investor of the year - created a fund based on the index, which has had enormous success.
The Shiller Barclays Cape US Sector index seeks exposure to cheap sectors of large companies and is designed to outperform the S&P 500. As of May 13, the index had outperformed that benchmark by 2.36% in the year to date. DoubleLine created an index overlay to gain exposure to the index through a total return swap, with the remaining assets invested into its own bond portfolio, which it actively manages.
"DoubleLine is an active manager, so running an index is generally not high on our list of things to do," says Jeffrey Sherman, a portfolio manager at DoubleLine who with Jeffrey Gundlach co-manages the Shiller Enhanced Cape fund in Los Angeles.
"The Shiller Barclays Cape US Sector index was an interesting idea but we didn't just want to run an index product. We wanted to add value and come up with a strategy whereby we could try to add at least 100 basis points to the index returns. So we approached this with a hedge fund mentality, using an absolute return focus to try to outperform cash," he says.
When the firm designed the bond portfolio, Sherman says it wanted to outperform cash each calendar year, so it set up a short-to-intermediate duration risk bond portfolio with the flexibility to take credit risk where appropriate.
"We kept the fund within a low-volatility banding - taking up to 200–250bp per year. The correlation means that since inception it has not added to the volatility of the overall structure, but, importantly, it gives us the chance to add alpha every single year," he says.
In fact, the fund has outperformed its 100bp target. Sherman says it has achieved a 3.2% annualised return over the S&P 500 since its inception, despite a slowdown in risk appetite in 2015 and the beginning of 2016.
"Last year we got risk averse because we saw a deterioration of credit markets here in the US. We took a lot of risk down in the portfolio but we still achieved more than 120bp gross on the fixed-income portfolio. We rely on our expertise in macro allocation to navigate the fixed-income markets, and when we think the time has come to take risks we will do so. But when we believe the time has come to be conservative like today, as we have for the last nine months, then we keep risk down," says Sherman.
When the fund first launched, Sherman was so confident in the potential of the investment strategy that he predicted DoubleLine could raise $1 billion of assets under management within three years. Everyone laughed at the suggestion, but at $930 million to date the mutual fund is almost there, and he believes there is a total investment capacity of $20 billion across all funds in the long term. This includes a variable annuity fund that has gained support from Jackson National, an insurance services company. The fund has only been live since September 2015, yet it has already attracted $675 million in investment to date.
"If we are in a mid-single-digit-return environment for US equities, adding an additional 100–200bp over the index would be significant outperformance and is why these structures can really shine. We expect this to be a very significant project in our line-up," says Sherman.
Both DoubleLine and its dealer counterparties - Bank of America Merrill Lynch, Barclays and BNP Paribas - are required to collateralise mark-to-market positions on the swap, and the margin is held in a segregated account at a custodian. A negative mark-to-market move won't cause problems for DoubleLine, however.
"We are not forced to unwind the fixed-income positions due to a decline in the market value of the index. Instead, we can post the assets as collateral against the mark-to-market loss. This feature allows us to maintain our view through the fixed-income portfolio irrespective of the price action in the index," says Sherman. "Further, where there is equity market appreciation our counterparties are required to post collateral with our custodian. Assets are always held at a third party, helping alleviate concerns about what happens to the embedded gains if the counterparty goes out of business."
The week on Risk.net, July 7-13, 2018Receive this by email