At GAIM 2016, we had an opportunity to speak to Tim Barrett, Associate Vice Chancellor and CIO at Texas Tech University System, about how he’s implemented a derivatives programme at the endowment and why.
What kinds of derivatives are most important today for managing risk in the portfolio?
We view derivatives as a cost efficient way to implement beta as well as an effective tool to manage risk. From an equity perspective, we use derivatives to gain passive exposure in markets replicating the MSCI ACWI (an index of worldwide equities performance). Futures are an important tool to gain that exposure cheaply, but to be clear – the primary advantage with futures is capital efficiency and the ability to quickly adjust exposures. Generally, we use futures when options pricing is not attractive. From an options perspective, we are able to implement risk reversals which means we sell, for example, a 5% out of the money put, using the proceeds to purchase at the money calls. This creates 5% downside protection and typically accelerated upside, for instance 115% upside. In other words, an up/down capture of 115/95. Last, we do utilize swaps as well. For instance, we have implemented risk premia, or smart beta, in a swap format to diversify our equity portfolio. This is effective risk management within the equity portfolio. We have implemented commodity roll yield swaps to capture the roll yield risk premia. More recently, we have implemented two different tail hedge swaps as we believe systemic risk has substantially increased.
Is it actually worthwhile to use active managers?
In short, absolutely. We are primarily an actively-managed endowment in that only 20% of our beta is achieved via derivatives. As to active equity mandates, we are strong proponents [for this approach] as you move to less efficient markets; we utilize active managers in small cap, emerging markets, regional mandates, as well as specialty strategies, such as event driven and activist. However, we tend to focus on concentrated managers with high active share when we are truly targeting alpha because we already have the tools to gain broad equity exposure via the derivatives. Our credit portfolio as well as our private portfolio are purely active mandates.
How do you bring risk management in-house, and what are the benefits of this approach?
In my view, risk management is already managed internally at most institutions. How one institution implements [this] compared to another varies greatly, but it is a cardinal task of any CIO. For instance, in my previous life managing corporate plans I looked after a combination of managers and derivatives to obtain the appropriate liability overlay; clearly a risk management programme. Building a programme without derivatives is still an exercise in putting the pieces together in an attempt to build the best targeted risk-adjusted return. We simply believe that derivatives are a tool that makes that job easier. If an institution wants to implement a derivatives program, whether to hedge or simply obtain beta exposure, the easiest way to implement is through an implementation manager. In the US, Russell Investments, Clifton Group and NISA Advisors will act as a fiduciary and ensure best execution which eliminates the need to negotiate ISDA agreements or have a trading and back office operation. These programs can be fully staff-driven, to policy-driven with little staff leeway. Thus, there are ample ways to structure a program and take small steps in order to get a board and your staff comfortable.