These days asset management firms merge with great frequency-often creating colossal new entities with billions under management. But when TSA and Analytic Investment Management became Analytic·TSA in January of this year, the union was based on more than just a search for volume. For though the building blocks were global asset allocation and option-based volatility forecasting, the cement was strategy implementation through the use of derivative instruments. Far from being frightened of derivatives, both firms willingly embrace the use of these instruments to achieve optimum returns for their clients with speed and simplicity.

Both firms realized that to compete in the next millennium, they needed to be able to offer multiple strategies and products. But derivatives usage was and is central to the ethos of both firms, separately and now together. As Alan Adelman, president and CEO of the new firm, says: "Risk management is not something new or trendy to us. We've been at it a long time. We are able to carefully craft portfolios to meet specifically targeted levels of risk." Roger Clarke, who was chief investment officer with TSA and retains that post in the new firm alongside Alan Lewis, echoes these sentiments. Explaining the attraction of a merger with Analytic, he says, "As a firm TSA was moving toward developing option-based strategies and we looked at Analytic's 20-some years of experience in this area as a real plus, not only with research but on the trading side as well." Talks between the firms began in early 1995.

Dynamic duo

The merger with TSA gave Analytic the global reach it has hitherto lacked; TSA had been investing in non-U.S. currencies and securities for over 10 years. The new firm now has $2.3 billion under management, but in five to seven years, it hopes for $10 billion. To grow by about $2 billion every eighteen months is clearly a very ambitious target, but Adelman believes the special characteristics of Analytic·TSA give every reason for optimism. "We truly believe our strategies are strategies of the future. They allow the investor to look for mispricings in a wide variety of asset classes and countries and deliver results in a consistent fashion," he says. The new firm is unique, he claims, "because it is small enough to respond quickly to serve clients and yet compete in the institutional marketplace."

Analytic Investment Management has been around for as long as the listed derivatives market. It was founded in 1970 by an academic from the University of California and initially used heavily quantitative valuation models to assess the worth of stock warrants and convertible debt. However, when the options market was born in 1973, the company found its métier. It has been using both the exchange-listed and OTC derivative markets ever since to generate the best returns possible for its investors. Adelman notes, with some pride, that Analytic began to use options around the same time that Fischer Black and Myron Scholes began their pioneering work on option pricing.

Analytic's hallmark, then as now, was to use its battery of volatility forecasting techniques and other quantitative methodologies to identify options that appeared mispriced when compared to the implied volatilities. The emphasis, during the spectacular market swings of the 1970s, was to produce a risk-reduced hedge strategy. "Combined with the underlying equity and options market we were able to provide investors with risk returns that were quite favorable," recalls Adelman.

With the 1974 passing of ERISA, the umbrella legislation governing the operations of pension funds, a flood of new money suddenly became available. The funds under management at Analytic increased to $1 billion. But the firm was not tempted to eschew its traditional strategy with this influx of new capital and remained committed to its bread-and-butter business of forecasting volatilities.

When Roger Clarke founded TSA 10 years later in 1985, he too adopted a derivatives-friendly approach. Clarke was one of the first managers to develop tactical asset allocation strategies for his clients. But once the decision to buy a given security was made, he chose to use the derivatives markets rather than the cash markets to achieve that exposure. Later in the decade TSA began spreading its wings overseas and taking advantage of opportunities in what it perceived to be undervalued currencies and countries.

Though both firms maintain that the merger was a marriage of equals, Analytic certainly seems to be the senior partner. Technically, Analytic (through its parent company, the money management conglomerate United Asset Management, or UAM) bought TSA. Adelman maintains that this was simply vehicle that allowed Analytic to buy out TSA's outside investors. Observers might find some significance in the fact that while Alan Adelman is CEO and president of the new company, Roger Clarke, who used to run TSA, is now chairman of the firm's investment and policy committee and joint chief investment officer. Each firm brought about an equal amount of funds now under management to the new firm. As far as overlap, Adelman says the only duplication was in back office functions, with consequent redundancies. However, no investment officer left; there are now 26 professionals at Analytic·TSA.

Clients fall mainly into three categories: pension funds, both corporate and public; religious and educational endowments; and offshore and onshore commodity pools. High-net-worth individuals are clients, but only as investors in pools, not on an individual basis. Among the corporate and public pension funds are Southern New England Telecommunications Corp., Coca Cola Bottling Company United, the Teachers' Retirement System of the State of Illinois, the Philadelphia Board of Pensions and Retirement and the Chattanooga Firemen's and Policemen's Pension Fund. Endowment foundations that are clients include the Common Fund, the Southern Baptist Foundation and Pepperdine University. Analytic·TSA also manages investments for commodity pools like Prudential Securities Futures Management and Mitsui Corporation and mutual funds like CoreFund Global Bond Fund and Framlington Gilt Trust.

Of the $2.3 billion under management, around $225 million is invested in equity products, $215 million in fixed income, $480 million in designated global asset allocation and currency management, $178 million in cash equitization and fully $1.2 billion in option overlay programs.

Foreign ambition

Analytic·TSA is casting its net beyond the waters of the U.S. in the hope of snaring new clients. Its management believes European investors are becoming more amenable to the idea of quantitative strategies. To capitalize on this perceived opportunity it obtained a London base in May by merging with Alpha Global Fixed Income Advisors, which has been renamed Analytic·TSA International. Alpha Global was founded by a group of investment professionals that have been teamed together for over 15 years. It also shares the same approach to derivatives; it is heavily quantitative and has been using exchange-listed and OTC instruments for years. At the time of the merger, Alpha Global president George McNeill emphasized this feature when he said he was "pleased to join forces with a firm that is committed to staying at the forefront of quantitative investment research and methodologies." McNeill is managing director of Analytic·TSA International and is on the combined firm's investment committee.

The Asian market is also becoming more receptive, officers at Analytic·TSA believe, after the firm recently received a mandate from a Japanese-based institutional investor. UAM has an affiliate office in Japan which Analytic·TSA intends to use to pick up business in Asia. The firm is also hoping to recruit more alternative investors-funds that are looking for diversification by steering away from traditional investments in domestic stocks and bonds.

Multiple strategies

Underpinning the Analytic·TSA style is a jointly held belief in the power and efficiency of derivatives. Roger Clarke divides the use of derivative instruments into two main areas: hedging, and gaining exposure to the underlying market. For example, if an investor carried stock worth $100 million, but wanted to reduce that by 20 percent, say, during the recent market turmoil, it would be much easier and quicker to simply sell $20 million of futures contracts rather than sell the underlying. The only disadvantage of this strategy is that there must be enough cash on hand to fund margin calls.

Derivatives are also used to gain exposure. In this context Clarke mentions the so-called cash equitization strategy devised to optimize the market exposure of a client that is temporarily underinvested. For example, if a pension fund has perhaps five percent of its equity holding in cash, through an accumulation of dividends or a similar event, it is not fully invested. If the market goes up, the cash will act as a drag on the portfolio, costing the client around one percent in a year when the equity market rises 30 percent. Analytic·TSA can keep the cash fully invested in futures through the use of an overlay strategy.

The firm also creates synthetic funds. Last year a pension fund was aware that a lot of retirees were about to claim their cash, but was not sure how many. Rather than liquidate positions in the underlying, a liquid cash fund was created which was invested in the futures market. When retirees emerged to collect their pensions, the positions could be sold quickly enough to provide enough cash up front.

Listed preference

Analytic·TSA prefers to use exchange-listed products, but will move into the OTC market when exchange-listed products are not available or are more expensive. For example, investors interested in taking a view on the yield curve can gain exposure through an OTC model Analytic·TSA makes available. Currently, there are no yield curve contracts listed on any exchange, though the Chicago Board of Trade does intend to bring one out in September. An investor wishing to put on a steepening or flattening trade must use existing instruments in either the cash or futures markets, by buying five-year futures and selling ten-year contracts if he thinks the curve will steepen. However, this position still entails basis risk. The strategy offered by Analytic·TSA, which currently utilizes OTC instruments, is much cleaner as it simply compares the spreads between two given maturities, irrespective of price or any other variable.

For example, say that the current spread between three- and five-year notes is 40 basis points and the one-month forward curve implies a spread of 41 basis points. An investor takes the view that it will fall. He can strike a put at 41 with Analytic·TSA, and if the spread does indeed decline to, say, 30 basis points in one month, he pockets the value of 11 basis points. If the spread increases to 50 basis points, he loses the option premium.

Steve Pelletier, who trades these products at Analytic·TSA, says that there is little competition at the moment and that he has seen a lot of interest in them, despite the lack of liquidity. In addition, the international currency options program is "going like gangbusters," says Pelletier. There is also considerable interest in the international equity options program. All these strategies use econometric models to predict likely market outcomes. In the case of the yield curve product, the models are used to predict the probability of any changes in spreads between two specific points; a 50 percent rating would indicate an equal chance of steepening or flattening.

Outside counsel

Clarke notes that the biggest use of OTC products is in the FX market, an arena which is much deeper than any other. The firm has also set up some swap transactions for clients, and it provides outside valuation for clients who are dealing with an investment or commercial bank. "They want some comfort and an outside perspective," he explains. It is a growing business both for users and participants in the wake of a number of derivatives-related losses.

Last year the currency markets generated the best returns for Analytic·TSA's investors. Domestic products were less lucrative. Equity options in U.S. stocks brought in returns of a little over 100 basis points, just within the targeted return of 100­200 basis points annually. However, as Adelman notes, 1995 was not a volatile year in the U.S. equity and debt markets, and as a result those strategies which capitalize on options mispricing were somewhat constrained.

The bad press given to derivatives a couple of years ago affected the confidence some clients had in the strategies pursued by Analytic. "A good number of our investors have fiduciary responsibilities and have to answer to investment boards and committees, who of course responded to events like Orange County and Barings," comments Adelman. A number tried to scale back their exposure to derivatives. However, while there are "still some lingering doubts," Adelman believes these days are largely behind the industry now. He adds that because many of their clients are pension plans and endowments who have several billion dollars under management and are familiar with the derivatives markets, "they are quite capable of seeing the difference between exchange-listed options and the more heavily structured products and exotic derivatives like Procter & Gamble bought." He adds that Analytic·TSA, as a principal, fully hedges its positions.

The newly merged firm imposes a four-step procedure before any investment decision is undertaken. Initially it examines its research to discover perceived mispricings or market inefficiencies that have been uncovered. Then it develops proprietary valuation models to identify and judge the mispricings. If a mispricing is confirmed by the valuation, products are then structured and rigorously tested to see if they meet return and risk management criteria. Only after this thorough evaluation is a strategy presented for client consideration. These essential steps were common to both firms before the merger, says Adelman.

Few clashes of personality and philosophy arose between Analytic and TSA during the merger. Both talk of the consistent investment strategy between the two firms. A so-called "entrepreneurial" culture dominates the new firm, and the organization is kept as flat as possible with few layers of bureaucracy. "We try to look on ourselves as a collegial group of principals," says Adelman.

He adds that even during the heyday of enormous profit-making through the use of derivatives in the early 1990s, both firms took a very practiced and measured approach in their application of derivative security. In fact, at the moment, Analytic·TSA seems to provide a textbook example of a prudent investment management firm that has used derivatives both wisely and well. Hopefully this happy harmony will remain and provide the firm a basis for future success.

When Angelo Calvello was an executive vice president at Credit Agricole Futures, he spent most of his time evaluating commodity trading advisors (CTAs). CTAs specialize in the speculative trading of agricultural and financial futures, and Calvello was trying to identify the best for his bank's fund management group. "I'd seen a number of CTAs, but TSA stuck out from the crowd," he recalls. "Many CTAs don't try to-or simply can't-explain how they generate returns. They'll fall back on some proprietary algorithm that helps them forecast the markets. TSA came out and told me how they thought they could capture the return. They looked for certain inefficiencies, tried to substantiate those quantitatively and then built a valuation model to capture them over time."

Calvello was so impressed he joined the company. As director of client relations and business development, he is now positioning the firm's existing currency management and volatility arbitrage programs and developing new leveraged products. He's focused on moving beyond managed futures into the hedge fund arena. "The firm is already trading cash government securities and equities in a quantitative method that would be more acceptable to hedge fund investors," he says.

His target: institutional investors and high-net-worth individuals. CTAs have had a difficult time attracting blue-chip pension funds. Some early proponents, including pension funds run by the State of Virginia and Kodak, have scaled back their efforts after an initial trial. Although Calvello admits plan sponsors still have some reservations about managed futures, he feels strongly that "Being a money manager means more than just producing risk-adjusted returns." He adds, "It means understanding compliance, oversight, and the details of acting as a fiduciary."