Updated with correction.
Overlay managers are looking to expand their business by targeting smaller endowments and foundations — not just by managing a portfolio, but also by allowing those funds to use their trading desks for daily moves.
Sources said the tactical nature of endowment and foundation investing and the current low-return environment makes an external trading desk attractive to those funds.
“Endowments and foundations have a critical economic need — they need to meet a specific return to fund their required spending,” said Lisa Schneider, managing director, non-profits and health-care systems, Russell Investments, New York. “Private foundations are required to spend at least 5% of their assets each year, and endowments and other foundations, while not required, often have policies to spend about 5% as well. Increasingly in a low-return environment, we counsel clients to take advantage of every implementation vehicle they can, effectively through the use of overlays and derivatives, and sometimes via tactical tilts that trading can support.”
As an example, Ms. Schneider said, incremental returns can be gleaned “from splitting the country and the currency decision. Like with Japan, having exposure to Japanese equity but not having exposure to the yen. Tactical decisions are where the trading desk comes in.”
Larger endowments — such as those of Harvard University, with $36 billion in assets, and the University of Texas and Texas A&M University systems, with $37 billion combined, can operate their own desks. But for smaller operations, like the $700 million endowment at Wake Forest Endowment, operating an internal trading desk is too costly. Yet there's still a need to get that additional alpha that can be found by directing one's own trades, said Jim Dunn, CEO and chief investment officer at Verger Capital Management, Winston-Salem, N.C., which manages the endowment's assets.
“It's really hard to manage trades, to have all the market data necessary,” said Mr. Dunn, who was previously CIO at Wake Forest. “There are a lot of costs involved in work and talent. The Harvards and Texases may have that ability, but most endowments don't.”
Neither Mr. Dunn nor Garry Duncan, Verger president, would name the external overlay manager used by Wake Forest, citing confidentiality agreements.
Using an overlay manager to provide that directed trading service differs from a traditional overlay mandate, where a client gives assets to a manager to run as it sees fit in an overlay strategy, while a trading desk allows non-profits to use futures and options under the direction of the fund's investment officer, added Mr. Dunn.
“The trading desk gets direction on a specific portfolio, and we direct the changes they want to make, so clients can react to everything on a daily basis. Overlay management doesn't do that,” Mr. Dunn said. “Also, in the past, people would go to investment banks like Goldman Sachs to do this. But (proprietary trading) desks are dead. Now they've moved on to different ways to trade.”
Added Jack Hansen, Minneapolis-based chief investment officer at Parametric: “Dodd-Frank, Basel, Volcker, all make broker-dealers less attractive for one-off assignments. Those brokers won't take them on without terms that are less favorable to the client than what we provide.”
Clint Talmo, portfolio manager at Parametric, said “the goal is to be an extension” of an endowment's or foundation's investment staff. “Providing front- and back-office exposure to what they need. Front-end execution is important, and a lot of that is cumulative in nature. Some clients are very knowledgeable about this, others not as much. On the front end, if they have risk in their portfolio, what do we do for that. Also on the back end, we're checking on the regulatory and accounting aspect of this. From a client standpoint, do I want to hire a bunch of people for just one trade a month? It's too expensive and cumbersome to do internally.”
At Parametric, about half of its 200 institutional clients, with a total of the $70 billion in notional assets, use the firm to implement trades. “They do really nuanced trades, very intricate trades, margining of exposures,” said Mr. Hansen.
“In a low-return environment, every basis point is meaningful,” Mr. Hansen said. “If they have a 6% or 7% rate of return expectation and a 1% yield, everyone can do the math. So that's been a driver of this. So has the increasing importance of risk in a portfolio. What are my influences? How can we harvest volatility? It's risk control that pays you. Everyone should love that.”
The challenging nature of endowment and foundation investments makes being more tactical an important element of their asset allocation, said David Eichhorn, managing director at NISA Investment Advisors in St. Louis, which manages about $70 billion in notional overlay assets. Among its 44 overlay clients, about half use NISA to implement trades.
“On the asset allocation side, they generally have larger allocations to (illiquid investments) and other assets that are harder to synthetically replicate,” Mr. Eichhorn said. “It's more challenging to design. It often makes for very interesting strategy discussions and engineering. Where the (asset owner) CIO is more hands-on lends itself to this, and more endowments and foundations lean that way.”
NISA is a money manager, Mr. Eichhorn said, but as a derivatives overlay manager there are “two extremes of the services spectrum: the traditional mandate where a client will assign a mandate for NISA to manage in an overlay strategy, and a more open-ended implementation role on behalf of some clients whose derivatives are so intertwined with risk management that NISA will help implement that by adding an outsourced trading role,” he said.
Russell provides a similar spectrum of services, said Greg Nordquist, Seattle-based director, overlay strategies. “We primarily offer services as an investment manager, but with overlays, we act as an investment manager but also combine trading and asset management,” Mr. Nordquist said. “Our direct market access service, our physical trading desk, takes direct orders from clients including endowments and foundations. We can do pure trading on our agency-only trading desk acting as an execution broker, always on the client side.”
Russell's trading desk will trade foreign exchange and direct equities as what Mr. Nordquist called “a pure trading agent.” Meanwhile, futures and swaps will be handled by Russell as an investment manager. “FX is an area we can contract just as an execution agent. That's a growing business for us.” Russell has $81.7 billion in notional overlay assets under management.
Parametric's Mr. Talmo said while the firm provides trading services, “we're not a broker. We consider this part of outsourced exposure management. Clients may look at the total risk — say, the risk of exposure to the Chinese renminbi — and ask us if we can hedge that out.”
This article originally appeared in the January 23, 2017 print issue as, "Overlay managers offer small funds help on external trading".