CHICAGO - Brinson Partners Inc., never a proponent of derivative strategies, plans to plunge into the area by steeply leveraging its actively managed global balanced portfolios with swaps.
Brinson's goal is to significantly increase returns by increasing the risk through the use of the derivative.
"At virtually any level of risk, this portfolio" - Brinson's global securities portfolio of stocks and bonds - "swapped down or this portfolio swapped up would have been better than any manager that you could have hired at that chosen risk level," said Gary P. Brinson, chief investment officer.
Mr. Brinson, long hailed for his investment innovation, especially in pioneering global investing, is unveiling the new strategy after a year that saw widespread losses connected to derivatives and related leverage.
Indeed, Narayan Ramachandran, managing director of RogersCasey & Associates Inc., Darien, Conn., said, "Gary as a value manager may be just a little early." Because of the derivative and "deleveraging crisis of 1994," he said, "the marketplace may not be ready" for Mr. Brinson's strategy.
Edgar E. Peters, director-asset allocation, PanAgora Asset Management, Boston, "I think it's a nifty idea. But I'm skeptical that the investment community is ready for something like that.
"Most investors are very skittish when it comes to leveraging a portfolio."
Even Mr. Brinson conceded, "Our biggest concern is people will say, 'Oh, no, swaps and derivatives.' These things are tainted right now."
Nonetheless, most of the pension fund advisers and consultants who were interviewed, including Mr. Ramachandran, believe Brinson's is an attractive strategy in terms of return and safety.
"I think it's a compelling product," said Gary L. Gastineau, senior vice president and head of equity derivatives research, S.G. Warburg & Co., New York.
In addition, they all said, Brinson's long-term success as a money manager lends credibility to the new strategy.
More specifically, Scott Lummer, managing director, Ibbotson Associates Inc., Chicago, said, "If a pension fund wants to take more risk and has limited capital, this is a great way to take advantage of Brinson's strategy. The strategy is not based on anything to do with derivatives. It's based solely on the ability of Brinson Partners to beat the market."
The firm soon will begin making formal proposals to major pension funds, both existing clients and prospects, Mr. Brinson said; the firm expects to get $500 million to $1 billion from them by March or in the second quarter to begin investing. "I would say three-quarters of that would just be a transference of assignments we already have into this new mode," Mr. Brinson said.
"We would like to ... go out to clients and say we can deliver this portfolio to you at levels of risk that would vary depending on your objectives or depending on the discretion you would give us to alter the risk of the portfolio using the swap mechanism.
"By using swaps, an investor can accomplish the same thing that one could by borrowing," Mr. Brinson added.
The firm already has lined up two counterparties for the swaps. Mr. Brinson declined to identify them until the strategy makes its first investment. It's looking for more counterparties, although he said Swiss Bank Corp., which bought his firm last year, won't be one because of possible conflicts of interests under the Employee Retirement Income Security Act.
Mr. Brinson expects money market funds will be especially interested.
Mr. Brinson is promoting the strategy as more than just a sophisticated way to boost returns. He suggests the strategy - leveraging or even deleveraging portfolios with swaps - could be used to adjust the risk profile of an entire pension fund. Such a use, he said, would eliminate the need to hire and fire money managers each time a sponsor changed its risk preference. It would save the high costs of buying and selling equities and fixed-income to shift asset allocation.
But consultants believe the strategy's promise to boost returns, rather than its benefits as a high-tech, low-cost asset allocation tool, will determine how well it sells among pension funds.
"The idea of boosting returns will be of more interest to more clients," said Ibbotson's Mr. Lummer.
Brinson would receive its regular fee for managing the investments in the global securities portfolio, while it would set a performance-based fee on the part leveraged with swaps.
All assets earmarked for the new strategy will go into a new institutional-only, no-fee mutual fund Brinson is setting up. Bankers Trust Co., New York, will be custodian of the mutual fund, Mr. Brinson said, noting the complexity of the portfolio leveraged with swaps is beyond the ability of many custodian banks to handle.
Mr. Brinson calls the new strategy the "global frontier portfolio," deliberately reminiscent of the academic "efficient market frontier."
Under the strategy, clients will invest in Brinson's global securities portfolio of actively managed equities and debt securities. Brinson already runs $13 billion in global balanced portfolios, including $2 billion in a commingled fund.
A client would invest, say, $100 million in the new strategy. Brinson would place $100 million in the global securities portfolio. Then Brinson, depending on the client's risk preference, would leverage the portfolio by swapping, say, another $100 million with a third party.
In the swap, the client would agree to pay the counterparty an interest rate, typically the London interbank offered rate, plus a premium of 0.25 or 0.375 percentage points. In turn, the counterparty agrees to pay the pension fund client in U.S. dollars the return on the Brinson global securities portfolio over the period of the swap.
For the swap counterparty, the transaction becomes an arbitrage posing little risk, Mr. Brinson said.
"The counterparties will not be exposed to risk," he said. "The counterparty only loses if the pension fund defaults."
The deal presumes the counterparty can borrow, or acquire funds, from investors - such as those in a money market fund - at close to LIBOR. As a result, the counterparty receives an arbitrage profit from the spread between LIBOR it pays its investors and the LIBOR plus the premium it receives from the pension fund.
The counterparty, to hedge itself on carrying out its end of the swap, will invest $100 million in Brinson's global securities portfolio to receive the return swap counterparty promises to pay the pension fund.
In short, the pension fund, on a $100 million investment, would be doubling its exposure, or assignment, to Brinson to $200 million without having to invest another $100 million. Instead, the pension fund will pay for the use of that extra $100 million by leveraging through the swap.
As for liquidity, Mr. Brinson said the strategy would have daily liquidity, although he would ask clients to commit to the strategy for at least a year. "We don't want to use this strategy as a short-term trading vehicle," he added.
New computer software enables Brinson to price the portfolio constantly. "You'll know minute by minute, day by day, where the portfolio is," he said.
But Ibbotson's Mr. Lummer is cautious about liquidity. "With a company as solid as Brinson Partners, it's very likely liquidity would be there," Mr. Lummer said. While "everything I see shows liquidity is going to be there," he said, "certain market events happen - and you can't tell what - and liquidity isn't there and you're stuck with these in your portfolio."
RogersCasey's Mr. Ramachandran said, "If an investor wants to get out, I wouldn't assume it's immediately liquid. It's not illiquid, but it's not 100% liquid."
Mr. Brinson is designing the strategy around his global securities portfolio because he says it offers the best return per unit of risk. The portfolio, while paying a slightly higher return, substantially reduces risk, compared to an all-U.S. equity portfolio.
The client determines the amount of additional risk it wants to take by the amount it leverages with the swaps. On a $100 million investment with Brinson, a client could double its exposure with a $100 million swap, or increase somewhat less with, say, a $50 million swap.
A client could even raise the leverage above its investment with, say, a $150 million swap.
Mr. Ramachandran said a potential problem is how well institutions can quantify the risk level they desire.
"Now institutions state risk level vicariously through the amount they have in equities and bonds, rather than say, 'I want a, say, 10% risk level.'
"This whole approach will get more credibility if more work is done on quantification of risk level," he added.
"More work has to be done on how you capture buyers' risk level correctly."
Mr. Brinson will require clients to invest at minimum $50 million in the new strategy, because of the amount of work involved for his firm.
Mr. Brinson envisions the broader and more important use of the new strategy is for a pension fund to control its absolute risk level.
His new strategy moves away from traditional asset allocation and changing managers as the main way institutional investors control their risk, and instead uses swaps.
Under the traditional way you manage risk, Mr. Brinson said, you buy more equities if you want more risk; or you buy more bonds, if you want a more conservative position.
"The client is better served not by focusing on underlying portfolios (of managers) but on the level of risk" he can adjust by swaps, Mr. Brinson said.
Mr. Brinson believes in 10 years large pension sponsors will do swap overlays for their entire funds. "That would be the logical conclusion if people feel this is the right concept," he said.
