A simple solution for tracking error problem

SACRAMENTO, Calif. — CalPERS' Dan Bienvenue found a simple way to solve the complex problem of how to cut down tracking error in the pension giant's $30 billion internally managed international equity portfolio.

Mr. Bienvenue, portfolio manager for global equities at the $228.7 billion California Public Employees' Retirement System, Sacramento, turned to a relatively new instrument, the Chicago Mercantile Exchange's 10-month-old E-mini MSCI EAFE futures contract.

The new contract, based on Morgan Stanley Capital International's Europe Australasia Far East index, which tracks 1,140 stocks, provides a one-stop, U.S. dollar-denominated solution with a tighter predicted tracking error than multiple futures baskets.

"To get an EAFE exposure, a single U.S. dollar-denominated contract that trades in the U.S. time zone is very helpful. Its simplicity and tight predicted tracking make the difference, with the ability to simply own one contract, margin in one currency, and get both the equity and the necessary currency exposure," Mr. Bienvenue said.

The new contract helps Mr. Bienvenue handle a difficult challenge: adding foreign exposure in a universe that spans 21 countries, 11 currencies and 13 time zones. Using multiple country or region index futures can push tracking errors way above a 20 basis-point risk budget due to currency conversion, foreign exchange hedging and related costs.

CalPERS' international equity portfolio is benchmarked to the FTSE All-World Developed index ex-U.S., a corollary to the MSCI EAFE index, which tracks 1,140 stocks.

"For a core index portfolio with a stock-selection, long/short overlay on top, we have a roughly 20 basis-point risk budget vs. the benchmark. If we're wasting part of that risk budget on our futures basket, that is risk that we'd rather ‘spend' elsewhere," Mr. Bienvenue said.

"The (CME's) contract roll has gone very smoothly; the contract is based on something we like, and it gives us better exposure. The only thing we are not happy about, so to speak, is that there is not more liquidity," he added.

A whopping $1.5 trillion in the U.S. alone was benchmarked to the MSCI EAFE index by late 2006, which points to CME EAFE futures' potential for substantial liquidity. But many money managers are reluctant to take a futures position greater than 10% of open interest, the gauge of future trading volume.

As an incentive, the CME is waiving fees through this year for the contract, which trades nearly around the clock on its Globex platform. The only expense is clearing fees of $1.14 per contract, which is valued at $50 multiplied by the EAFE index's level.

Said David Lerman, associate director for equity products at the CME: "For years, plan sponsors and money managers have used baskets of country futures to replicate MSCI EAFE exposure. However, executing multiple futures contracts around the world leads to operational burdens and increased tracking error to the benchmark. The CME's MSCI EAFE futures contract eliminates these burdens and will hopefully substantially decrease portfolio tracking error.

"We see great potential in CME's E-mini MSCI EAFE futures."

John Capobianco, head of index and exchange-traded fund trading at Susquehanna International Group LLP, a Bala Cynwyd, Pa., market-maker in EAFE futures, agreed. "As more and more firms get comfortable with the EAFE futures, you will begin to see the market get tighter and thicker, just as it happened with the three other broad-based equity futures listed on the CME — the E-mini S&P 500, Nasdaq 100 and Russell 2000."

Simplicity and low cost were important factors for the Clifton Group, a Minneapolis-based investment adviser that manages its clients' cash positions via futures, such as the CME E-mini EAFE, to maintain asset allocation targets without a cash drag.

"We use futures to equitize cash at the manager level or at the fund level," said Dan Wamre, portfolio manager for equity derivatives. "We also use futures for transition management. When a firm is doing a search for another manager and holds cash, we can provide futures exposure to maintain the economic exposure to a certain asset class."

"Before the EAFE futures came out, we had to do an international replication with four or five contracts and also purchase currency futures," Mr. Wamre added. "With EAFE futures, we can basically replace a total of eight contracts, four for the individual regions and then four different currency futures contracts."

With MSCI EAFE benchmarking concentrated in North America, liquidity in the contract is expectably thin overnight. Susquehanna is considering extending market-making hours and is already handling on request institutional block trades in EAFE futures when a large enough size is not displayed, according to Mr. Capobianco.

David Resler, chief economist at global broker Nomura Securities International in New York, noted "when U.S. fund managers think about investing outside of North America, they really think in terms of the rest of the world. From the perspective of Asian or European investors, ‘global' means primarily investing in the U.S. or their own region. So it is not surprising that the primary interest in this futures contract comes first and foremost from the U.S."

But Ted Niggli, executive director at MSCI Barra, an index maker and provider of risk-management tools in London, sees the opposite: the potential for interest in EAFE futures outside of North America because of the global dimension of international portfolio management.

"The benchmark EAFE is used by U.S. pension plans and investors, but the managers could be based elsewhere. Quite a lot are based in London where the EAFE futures contract has been discussed for many years," Mr. Niggli said.

The MSCI EAFE index surged to 5,735.74 on Dec. 31, 2006, from 2,799.19 at the end of 2001. This has spurred a flurry of new index products in recent months in the popular ETF sector.

The Vanguard Group Inc., Malvern, Pa., is readying a FTSE All-World ex-U.S. ETF; Russell Investment Group, Tacoma, Wash., just launched the Russell Global Index, based on 63 developed and emerging countries; and Boston-based State Street Global Advisors in January introduced an ETF on the MSCI ACWI All-Country World index ex-U.S. on the MSCI All-Country World index.

San Francisco-based Barclays Global Investors' ETF on the MSCI EAFE index already is the world's second-largest ETF, with a market capitalization of $38.1 billion.

But Susquehanna's Mr. Capobianco noted, "There are fees associated with an ETF that are not applicable to a futures contract. The ETF provider charges 35 basis points to manage the fund, and there are costs associated with creating the ETF. We do plan on applying for specialist privileges in the Vanguard ETF. This will complement the EAFE contract and should help volume in the futures." n