The following comments respond to the Feb. 5 Others' Views commentary, "Secrets of enhanced indexing, securities lending," by Todd A. Tibbetts, manager-trust investments and foreign exchange, Sandoz Corp., New York.
Among other issues, the writers particularly question the definition of leverage in the use of enhanced strategies.
The author makes a few assumptions about the pricing of futures and forward contracts that need to be addressed. The first is that futures and forwards are priced (discounted) using Treasury bill rates. These contracts are not priced based upon T-bill rates but on the underlying asset repurchase or financing rate.
For example, T-bond futures are priced based on the cheapest-to-deliver Treasury bond and its associated repurchase or repo rate. If this were not the case, an arbitrage opportunity would exist and market forces would move in and earn excess profits.
Stock index futures, such as the Standard & Poor's 500, are priced based upon LIBOR, or the London interbank offered rate, this rate being the best proxy for the underlying financing rate for a portfolio of diversified stocks. This means that the price volatility of the S&P 500 futures is due to changes in stock prices or LIBOR or both. Therefore, if the cash portion of a cash-plus S&P 500 index futures portfolio is invested in T-bills, additional risks are assumed due to TED spread volatility, or the spread between the T-bill and Eurodollar deposit rates. The author's statement that if cash investments in a cash-plus-index-futures portfolio were made in anything other than T-bills, that additional risks are assumed is not true.
The second assumption is that T-bills are riskless investments. The U.S. Treasury is not a riskless issuer of debt, but happens to be the largest and most credit worthy issuer of U.S. dollar-denominated debt in the world. Credit is not the only risk that should be of concern. One risk of Treasury debt not mentioned in this commentary is a liquidity risk premium investors pay to hold Treasury securities. This premium is the mirror image of the liquidity risk premium investors receive for corporate debt and high yield bonds.
During a time of liquidity crisis, investors flee from high yield and corporate debt to T-bills. Immediately following such crises, investors dump their T-bills in favor of corporate and higher yielding securities. This postcrisis phenomenon for T-bills causes the TED spread to narrow significantly in the months immediately following a crisis and depresses the performance of U.S. debt denominated portfolios relative to other fixed-income portfolios. The author stated that the widening of the TED spread in late 1987 was an indication of the additional risks of holding a non-T-bill portfolio is incorrect but is in fact an indication of an increase in the liquidity premium investors paid (much lower rate) to hold T-bills during this crisis.
The author also stated that a cash-plus-index-futures portfolio is 200% leverage if the cash is not invested in T-bills. The author failed to take into consideration the return components of a futures position, which is the combination of a "long" asset position and a "short" cash position. Thus, the portfolio is along 100% cash, 100% S&P 500 index and short 100% cash (imbedded in the futures contract). Also, this strategy does not fit the economic definition of leverage set forth by the Association for Investment Management and Research in that the return volatility of the strategy is approximately equal to that of the index. This definition states "that leverage results when the return from a portfolio is expected to be proportionately more volatile than the return from a benchmark (unleveraged) portfolio." AIMR performance standards in this case require disclosure of the strategy and the use of derivatives.
Roger Clarke
Robert Harless is managed of structured products for Lotsoff Capital Management, Chicago.
In the commentary, the author defines leverage by introducing a rather bizarre concept of the risky asset. Specifically the author states, "Leverage is simply the act of having more than 100% of the underlying assets in an investment pool invested in risky assets" (emphasis added). Had the author shortened this sentence by three words and ended the sentence after the word invested, I would have few quarrels with his definition. In fact the definition of leverage used by the Association for Investment Management and Research refers to both an accounting and an economic sense of the word and such a sentence would happily coincide with the AIMR accounting definition.
Unfortunately, the author's definition introduces the notion of the "risky asset," which he defines in classic capital-asset-pricing-model style as anything other than Treasury bills. Without getting into a discussion of possible shortcomings of the capital asset pricing model for portfolio analysis, let me simply suggest that if I hold a "risky asset" instead of a T-bill and thus by the author's definition have introduced some form of risk, duration risk, credit risk, etc., this does not mean I have levered by position. I have altered the risk characteristics, but to refer to such a change as leverage strikes me as confusing.
On bond funds, the author suggests overweighting the risky components of a fixed-income index relative to less risky components is a form of leverage. While this may be a riskier position, calling it leverage is a poor choice of words and inconsistent with AIMR's definitions. I am not suggesting the author is wrong to call for disclosure of such a tilt or bias in a portfolio, just don't confuse it with leverage.
Finally the author introduces the "leverage balanced fund" as an index fund that uses cash plus futures instead of physical stocks. This is not only confusing, it runs directly contrary to the suggestions from AIMR on how to disclose such positions, namely as index funds with potential tracking error and not to try to attribute any alpha (positive or negative) to the futures trades relative to stocks alone - i.e., the strategy should not be disaggregated for reporting purposes. Such enhanced indexers should disclose that they are using futures and should clearly define the asset classes that may be considered "cash investments," but to call such strategies leveraged funds would be confusing and possibly dangerous. It would practically invite truly leveraged funds to capitalize on the resulting confusion. Let's not misuse the word leverage as some catch all phrase for strategies involving "risky assets."
The solution: Disclose the mechanics of any strategy. If the mechanics involve buying more asses than the fund's net assets (accounting definition) it should be disclosed as leverage. If the fund uses derivatives that have a net long notional amount in excess of the net assets, it is also leverage. If the fund uses derivatives with equal notional amount to the net assets, disclose the potential sources of basis or tracking risk and discuss the mechanics of any derivatives strategy in more than sufficient detail that any and every reader will precisely understand the risks of the fund.
Gordon Holterman is director and co-manager of Swiss Bank Corp.'s West Coast coverage group, San Francisco.
Searching for enhanced returns usually generates additional volatility or tracking error relative to the index return. This volatility could be generated by taking on more market exposure than the notional value of the underlying assets. Such an increase in dollar exposure would reflect the traditional notion of leverage.
However, tracking error that is generated by changing the risk profile of an investment without changing the notional investment value is usually not referred to as leverage.
For example, consider the same dollar investment in two equity portfolios, one invested in utility stocks and one invested in technology stocks. Though the two portfolios have different risk profiles, we would generally not consider the more volatile technology portfolio to be leveraged relative to the utility portfolio.
Nevertheless, the utility portfolio's risk could be increased to a comparable level of the technology portfolio by buying a few additional equity index futures. Some would call this a leveraged position while some would refer to this as just an increase in the portfolio's beta for the same dollar investment. In like manner, equal dollars invested in Treasury notes would generally not be considered to be leveraged relative to a Treasury bill portfolio.
However, the purchase of a few Treasury note futures contracts as an overlay could create a position of similar risk to that of the note portfolio. This overlay might be considered by some to be leveraging of the Treasury bill portfolio while others would consider it as only an extension of the portfolio duration equal to that of the Treasury note position.
The inadequacy of leverage as a descriptor is reinforced by noting that because of diversification, a leveraged strategy may have less risk than a non-leveraged strategy if component returns are less than perfectly correlated.
I encourage full disclosure of the risk structure of investment strategies. However, the traditional notion of leverage is not necessarily an adequate descriptor of risk in helping plan sponsors evaluate the source of value added and the corresponding impact on risk.
Roger Clarke is chief investment officer for Analytic/TSA Global Asset Inc., Los Angeles.
