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Play Markowitz for Me

Ferrell Capital's new trust allocates by volatility instead of asset type.

By J.C. Louis

These days, more and more proprietary traders at investment banks are being paid not on their returns but on how much risk they took to get those returns. Although the sell-side is rapidly embracing the concept of risk-adjusted returns, the buy-side may not be making full use of the advantages of portfolio theory proposed by Harry Markowitz more than 40 years ago.

Ferrell Capital Management, an investment management and risk advisory service, is preparing to launch an investment trust for institutional investors that it hopes will push investors from asset allocation to risk allocation. Prospective investors select from a series of volatility levels-5 percent, 10 percent or 15 percent. The trust then seeks the highest possible returns from within that targeted volatility through the active management of multiple-asset managers.

This offensive risk-allocation aggregates manager styles, asset allocations and the actual security positions on a single measure of risk-adjusted return-the Sharpe ratio. (The Sharpe ratio measures risk-adjusted return as the difference between the gross return and the risk-free rate, divided by the volatility.)

"Everyone talks about managing risk relative to a benchmark, but the benchmark is where all the risks are," says Bluford Putnam, president of CDC Investment Management. In other words, if the benchmark is wildly volatile, and you are trying to beat the benchmark, your returns on a risk adjusted basis might still be poor. Instead, the trust uses volatility itself as its benchmark.

In a declining-rate environment, for example, a fixed-income client in Europe may feel the need for more yield but may be hesitant to use equities, which carry twice the risk of bonds. "What they need," observes Putnam, "is a volatility targeted vehicle that can diversify across many strategies, including equities, but with a volatility targeted to the European bond market."

The approach is a radical departure from conventional pension management. "In conventional pension investment, allocations are shaped around investment guidelines that allocate dollars based upon duration constraints, credit restrictions, style limitations," says William Ferrell, president of Ferrell Capital Management. "These portfolios are then rebalanced once per quarter, diversified often with illiquid or exotic securities and calibrated with historical 'ex-post' correlation estimates of questionable accuracy."

Instead of this conventional long-only investment posture, the trust tries to reduce correlations with the equity or fixed-income benchmarks by using long/short strategies. "Long-only investing is like playing the piano with the white keys, but not the sharps and flats," Ferrell says. "Long/short investing takes more advantage of Markowitz than traditional portfolio management." It also manages the portfolios more dynamically with more liquid securities using more sophisticated correlation and diversification techniques.

The trust implements the strategy by using a number of different managers in the same asset class who have different styles. Managers who use a long/short approach to growth stocks, for example, have relatively low correlation with managers who use a long/short approach to value stocks. "If you have a volatility target, you can diversify to achieve that target," says Ferrell. "You can use multiple asset classes, countries and management styles to diversify and lower the volatility of the portfolio."

The trust then manages the managers by closely monitoring their positions using a Value-at-Risk calculation corresponding to the appropriate volatility level. The trust will look at the asset manager's underlying strategy, style and its allocations and raw positions, asset by asset, and then aggregate them. This close daily "ex-ante" position monitoring will reveal and signal an adjustment, for example, if too many managers are exposed to one country or asset type.

"We look at what they are doing every day," says Ferrell. "When correlations go up, we adjust exposures. To target volatility, we can change allocations, have the managers change their position sizes, or simply overlay a hedge. If the Deutsche mark is volatile, we can dial down the amount traded from a $70 million position to, say, $50 million." In this way, says Ferrell, "we're playing Markowitz with three or four traders and perhaps 10­14 strategies.

The fund will also use leverage to optimize a portfolio around a target volatility. "If you find the right mix of asset classes and styles that give you the top return for a 5 percent preselected volatility," asserts Ferrell Capital chief investment officer Richard Zecher, "the best way to maximize return for a 15 percent target volatility may be to leverage the 5 percent portfolio mix to the higher target."

Ferrell's incentive fee is also pegged to the net risk-adjusted performance, measured by the Sharpe ratio. "Hedge funds take a ton of risk without telling you what they are doing," says CDC's Putnam. "If Ferrell makes a fortune on a position that has a ton of risk, they do not get paid. The difference is extraordinary."


Commodity Users Struggle With Disclosure

By J.C. Louis

Companies that use financial instruments to manage currency and interest rate risk are all too familiar with the problems associated with the financial disclosure of derivatives instruments. Most have watched carefully over the past few months as the Securities and Exchange Commission moved to require increased quantitative disclosure of derivatives instruments in annual reports.

The new disclosure requirements, however, have caught many commodity users by surprise. "It's the first time that companies with commodity hedging exposures have had to report on their activity," says Elizabeth Glaeser, director of the corporate markets group at Deloitte & Touche. In the past, companies with commodity exposures were not required to disclose fair value of their hedge positions. Although inventories and transactions settled by physical delivery are excluded from regulation, companies that use commodity contracts settled in cash or with other financial instruments such as 90-day futures face the same reporting requirements that larger financial institutions face.

The SEC gave registrants a range of possible quantitative representations-tabular listings of fair value information and contract terms, sensitivity analysis, or a Value-at-Risk measure. But a number of groups protested extending the disclosure requirements to commodity transactions altogether. The Financial Executives Institute (FEI), for example, opposed the inclusion of commodity instruments settled by physical delivery in the new regulations. These instruments, it maintains, are no different from purchase orders or physical inventory. "The fact that a company enters into avariably priced purchase order for a commodity," declared a March 1997 FEI letter to the SEC, "and then uses the commodity market to fix the price...via a futures contract...is the same as entering into a fixed-price purchase order with its supplier."

The commodity requirements seem particularly irksome to these users because most commodity positions are deeply integrated into the procurement, production, sales and marketing chain. "Why does the commission believe that users are better served by knowing that an enterprise has purchased a copper forward by means of an exchange-traded instrument, but have never felt the information to be sufficiently interesting to request analysis of open purchase orders?" asked Philip Ameen, vice president and comptroller of General Electric, in a letter to the SEC before the announcement.

The Treasury Management Association (TMA) went further, objecting to the qualitative discourse rules as biased against firms engaged in financial instrument transactions. It noted that a grain miller that purchased a farm as a hedge against its wheat purchases is not subject to reporting requirements. Such "vertical integration hedges" can go unreported while a partially hedged producer using futures is required to produce lengthy disclosures of its primary risks. "Such requirements will only create the perverse result of discouraging hedging activities...and encouraging...unhedged risk profiles."

Critics also argued that the tabular method of disclosure, one of the SEC's three disclosure alternatives, would give away far too much competitive information on commodity holdings. "The tabular method is point-specific," says Deloitte & Touche's Glaeser. "It shows underlying exposures that could disclose competitive commodity positions. There is a huge amount of sourcing activities involving futures that has never been part of financial disclosure." Bruce Domash, senior manager of the audit department of the Chicago Board of Trade, agrees. "Competitors could glean what direction the firm is going in the market," he says.

Before the SEC decision, Hershey, a commodity-oriented company with a powerful stake in the outcome, campaigned actively in favor of a disclosure methodology that would protect proprietary information concerning the sizing, hedging and pricing of its cocoa positions. Robert Rosenbaum of the law firm of Arnold and Porter, which represented Hershey, argued that the company "demonstrated that you could easily reverse-engineer sensitivity analysis or Value-at-Risk disclosures, and thereby determine from them the position that the company has in the commodity market." This was particularly true for a company heavily concentrated in one commodity.

The SEC responded by permitting quantitative disclosure of market risk based on a netting of the futures position with the underlying commodity or physical procurement. For example, if the company procured $1 million worth of cocoa and purchased $600,000 in futures contracts as a hedge, the company would make a Value-at-Risk calculation based on the $400,000 of unhedged procurement contracts at risk. Since disclosure is made solely on the difference, it would be difficult or impossible to determine underlying positions. "Because the futures market and competitors do not have access to both sides of the equation," says Rosenbaum, "it is more difficult to reverse-engineer the disclosures and derive proprietary information."

Some consultants, however, have tried to point out something overlooked in the debate-that the SEC disclosures exercise could help commodity companies better understand the risks they are exposed to. Bill Foote, senior manager of risk management and regulatory practice at Ernst & Young, notes that commodity firms with wholly or majority-owned commodity trading arms ancillary to the core business should benefit from the mark-to-market and Value-at-Risk calculations. "One purpose in SEC disclosure is to provide better information to assess the financial quality of a firm," he says. "A firm that lowers its risk by effective hedging can utilize the disclosure mandated by the SEC to convey a clearer picture of the company's financial strength. The company's bond rating can improve and the cost of capital can decline, enhancing shareholder equity."

But others doubt whether the SEC mandates will serve any useful purpose for commodity companies-or anybody else. "Nothing has stopped commodity users from rigorous risk analysis of their positions to date," says Ken Lehn, professor of business administration at the University of Pittsburgh "They don't need the SEC mandates to do that. The power of SEC disclosure to lower the cost of capital is overrated. Investors are unlikely to gain valuable information from Value-at-Risk or fair-value disclosures. These will probably not achieve the SEC's goals of rendering disclosures between companies comparable."


The Great Franco-American Tech Swap

By J.C. Louis

Exchanges have spent fortunes developing systems to trade and clear the irproducts, and each has developed separately, forcing member firms to deal with each exchange on its own technological terms.

A major technology swap between American and European exchanges, set to be completed this summer, promises a new level of standardization and operational harmony that may reduce clearing costs and streamline front- and middle-office management for clearing member firms.

Last month, the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX) officially adopted the Paris Bourse's NSC trading system, which has been modified for derivatives trading to serve as MATIF's after-hours trading system. In return, the Paris markets adapted Clearing 21, a clearing system developed jointly by the CME and the NYMEX. The swap plans to breathe new life into the CME's GLOBEX system, which was flirting with technological obsolescence. (See box.)

The key change occurred when the MATIF agreed to adapt the Paris Bourse's NSC system for after-hours derivatives trading. "The Bourse always had a strong expertise in electronic trading focused on the equity market," says Francois Guy, deputy managing director of MATIF in charge of information technology. "We had the back-end engines for matching transactions and only had to develop it for derivative products."

The NSC's open architecture is a harbinger of a new standard for electronic trading. Under the older systems, a trader wanting to access different markets needed a separate workstation for each separate market. Open architecture allows traders to work within the same graphical interface on any market in which they have authorization. Another hallmark of this new standardization, says Ellen Resnick, a spokesperson for the CME, will be dial-up access that will let traders use any desktop or notebook computer to access the system.

"We're very excited by the idea of offering members a single platform with other exchanges," says Nacamah Jacobovits, a NYMEX spokesperson. "We like the idea of not having to train staffs in different systems, which will certainly lower expenses for member firms." NYMEX and the other exchanges view increased screen trading as a good way to support certain low-volume contracts during the trading day, build liquidity and provide a nurturing environment for new products from different time zones.

The exchanges are also eager to tout the cost-saving advantages of Clearing 21, the CME's flexible, electronic real-time clearing system that was developed jointly with NYMEX. The Merc's 81 clearing member firms are already using Clearing 21, which will be fully operational at the Merc by the end of the year and at NYMEX in early 1998.

Clearing 21 allowed the CME to give up the antiquated mix of main-frame computer systems and manual processing used to clear trade and position data. The onset of after-hours electronic trading only underscored existing inefficiencies. But the momentum behind the parallel Bourse-MATIF and CME-NYMEX joint ventures could carry well beyond the present technology swap. Once a standard is in place, notes Jacobovits, it becomes much more efficient and less costly for other exchanges to adapt the new standard than to maintain a separate, less compatible system. "Just as there is no need to redevelop electronic trading on the American side, there is no need to redevelop the clearing system on the European side," says the MATIF's Guy. "Once you can trade and clear derivatives with the functionality of the equity market, you have a world system in place that will enable anyone on any platform to access the complete range of products in any capital market."


Bourse Deal Saves GLOBEX

By Simon Boughey

The technology swap agreement between the Chicago Mercantile Exchange (CME) and the Paris Bourse did not come a moment too soon for the CME and GLOBEX. The exchange's agreement with Reuters, GLOBEX's creator, is due to expire in April 1998. If the CME had not signed a new deal with the Bourse to hook up to the NSC, it would have been facing "technological oblivion," as one systems analyst put it.

Under the terms of the arrangement, the CME and the New York Mercantile Exchange (NYMEX) are to adopt the Bourse's NSC system for after-hours trading. In exchange, the Paris market will use the Clearing 21 system developed jointly by the CME and NYMEX, so no money actually changes hands. The NSC system is due to be implemented by November 1998, and the name GLOBEX is still to be used, even though it will bear no resemblance to GLOBEX as it was originally conceived.

GLOBEX has had a famously checkered history. It was born in 1987 in a star-crossed arrangement between Reuters, the CME and the Chicago Board of Trade. Reuters agreed to provide all the cash, hardware and software, and the exchanges the products. Four years later, when the system was finally launched, it was already technologically out of date.

The Chicago Board of Trade (CBOT), pulled out in 1994, dealing a serious blow to the project. The Board then went on to develop Project A, its own after-hours system, which has become increasingly successful in recent months. MATIF also joined the consortium, but when it decided to pull out early in 1997, the system was clearly in its death throes. It never succeeded in attracting other exchanges, and consequently never generated the planned revenues for Reuters.

The mess in which the CME found itself has led to a reversal of the fortunes of chairman Jack Sandner. CME sources say that Sandner was never really interested in after-hours systems, as they threatened the brokers in his power base who viewed any automated system with suspicion. Without support from the top, GLOBEX foundered, and some members of the exchange grew dissatisfied with Sandner's leadership.

The end result? The return of Leo Melamed, who first promoted the GLOBEX system a decade ago. "We started out in first, but all of a sudden we fell behind technologically," says one CME heavyweight. "The membership was aware of that and pushed Leo back into a leadership role."


Competing EMU Models for Euroskeptics

By Robert Hunter

Not since the days of the "Who Shot J.R.?" craze has a more suspenseful international drama unfolded than the countdown to European Economic and Monetary Union. Pundits around the world are voicing their opinions daily on the likelihood of EMU by January 1, 1999. Germany's obsession with the mark, England's obsession with its colonial past and France's obsession with "Frenchness" have provided ample grist for the mainstream press.

But these stories are for financial lightweights. For a quantitative assessment of the likelihood of EMU, JP Morgan and Paribas are offering two competing sets of statistical models that claim to offer unbiased, market-based approaches to EMU predictions. Making predictions is always a shaky proposition, but these models try to crunch out a vision of the future without a crystal ball.

JP Morgan was first out of the gate when it unveiled the EMU Calculator, an index that measures the statistical likelihood of EMU based on market probabilities. The probabilities are based on the assumption that long-term interest rate spreads between the European countries involved are influenced by the market's expectations of EMU, which are pegged at either 100 percent probability or 0 percent probability. At any given time, the markets will trade between these two probabilities, and the closeness with which the market approaches either of these extremes indicates the relative probability of EMU.

The model uses Germany as its baseline, assuming (perhaps incorrectly in light of recent events) that the probability of Germany and one other country joining EMU on January 1, 1999 is 100 percent. The probability of, say, France joining EMU is calculated by comparing three spreads-today's post-1999 forward swap spread between French francs and German marks, the market's 100 percent probability of EMU, and the 0 percent probability. The mathematics are straightforward: EMU probability = (actual price level - no-EMU price level) / (EMU price level - no-EMU price level). One slight problem: the model can produce probabilities higher than 100 percent.

Since spreads are determined only by the expected changes in exchange rates, if the market is 100 percent certain today that EMU will happen by 1999, today's post-1999 forward swap spread between, say, lira and marks would be zero. The no-EMU swap spread is a bit more complicated. JP Morgan looks at a period when expectations of EMU were known to be quite low and performs a statistical regression of swap spreads, focusing on the difference between actual, estimated and EMU levels.

Paribas criticizes the model in four main areas:

  • Forward swap spreads indicate a great deal more than simply the probability that a country will join EMU. Global currency trends, such as a strong dollar or yen, will make spreads converge as well, and the Morgan model, which Paribas calls the "Simple Model," would automatically attribute smaller spreads to an increase in the probability of joining EMU.
  • The Morgan model uses historical spreads from the 1980s, but today's global economic climate is much different.
  • The model is unnecessarily rigid in its assumptions that countries either will join Germany in EMU in 1999 or will not, ignoring the possibility of a country joining after 1999. This rigidity pushes the probability results higher than they would be if other scenarios were considered.
  • The model relies too heavily on historical averages, which can vary significantly depending on which time period is chosen.

As an alternative, the bank offers what it calls modestly "The Superior Model." Like the EMU Calculator, it looks at forward swap spreads, but assumes that countries could join in 2000 or in any year after that. The model looks at one-year rates, since the countries who will be joining in 1999 will have identical one-year forward rates, and these will be lower than those of the countries not joining in 1999. The spread of one-year rates between each country and Germany can be used to determine the market's belief in a country joining EMU in 1999. The key to the model is that it assumes that the spread is normally distributed around its mean or average spread. The probability is calculated based on the size of the area on the distribution curve beneath Morgan's EMU Calculator spread.

It's important to remember one thing: predictive models, no matter how complex, can often be utterly useless. Like that famous episode of "Dallas," no one will really know how EMU will play out until it does.

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