When asset classes fall in sync, as bonds and equities did in 2008 and 2020, investors seek new uncorrelated assets to truly diversify their portfolios, say fund managers.
Whitecroft Capital Management partner and portfolio manager chief Michael Sandigursky said since its inception in 2016, the firm has solely focused on the Credit Risk Sharing (CRS) strategy, becoming the lead player in the US$50 billion sector.
“Up to 30 banks now use CRS transactions globally by sharing with investors the economic risks of their loan portfolios to core customers. In return for accepting these risks, investors are paid a premium by the banks”, he said.
“Conceptually this is very similar to insurance,’’ said Sandigursky at Investment Magazine’s Absolute Returns Conference.
“The major benefit for the banks to do these transactions is to get a regulatory capital relief … in this context the capital we talk about is the regulatory capital the banks are required to put aside for each loan that they originate.’’
Post GFC, the subsequent implementation of the Basel III framework had dramatically increased capital requirements on banks and so banks’ capital had become a scarce resource.
“Since then, the banks have been running a persistent negative operating gap, meaning that their return on equity is lower than their cost of equity,” Sandigursky said.
“Clearly this is suboptimal for shareholders and banks have been busy restructuring their operations ever since. Managing capital has become an ultra-important task of the C- suite of the bank and more so, the regulatory pressure on the banks doesn’t seem to be subsiding either.”
“There are more and more initiatives put forward by the regulators globally all the way up to 2024 and even beyond.”
Sandigursky said the credit quality of these CRS books was typically “very strong”, ranging between A to BB with consistently lower defaults compared with the S&P index, thus the strategy having low correlation with other asset classes.
“The key benefits of CRS are portfolio diversification, attractive returns and specialised alpha that we can extract as well as stable cash flows, low volatility and correlation and, more recently with rising rates, floating rate nature of the coupons,’’ he said.
In the past decade the market had grown significantly with 50-60 transactions issued each year equating to US$10 to US$15 billion of new capital invested every year. This allows large investors like European, Canadian, Australian and US pension funds to get involved in a meaningful way.
“CRS coupons are fairly stable through time and range between LIBOR plus 8-12 per cent,’’ he said. “In current markets this would be around 10-15 percent, we believe it is very attractive on a risk-adjusted basis”.
“A key factor of a CRS strategy is diversification and granularity of the portfolio exposures. For example, Whitecroft’s flagship fund has exposure to 25 portfolios referencing core businesses of 11 banks,” he said.
“This is more than 16,000 different obligors in 37 industries and 70 countries. I think it’s challenging to find such diversification elsewhere. The portfolio has strong credit quality with 70 per cent being equivalent to investment grade.”
Sandigursky said CRS strategy was really unique. Whitecroft’s philosophy is that CRS strategy is not a pure credit strategy. The major component of returns is banks paying for utility of having access to regulatory capital.
“So harvesting this premium is the main purpose of the CRS strategy,’’ he said.
“It is approximately three quarters of the risk spread we receive. Of course, there is also credit risk, which can be broken into two parts. The idiosyncratic component can be diversified away to a large extent, whilst macro systematic part cannot be diversified, but can be dampened through use of macro hedges.”
Sandigursky summarised by saying, “given the above, it is not a surprise that a properly implemented CRS strategy results in a lower correlation to traditional asset classes and as such should be a part of institutional investors’ portfolio”.
Meanwhile Rishabh Bhandari, senior portfolio manager at New York-based US$9.5 billion alternatives asset manager Capstone Investment Advisors, said the firm had a spectrum of strategies that leveraged volatility and derivatives to diversify.
“When constructed and executed properly and efficiently, volatility strategies can often be risk on strategies, so they make money during benign markets, but equally they can be mitigating and risk off strategies as well,” Bhandari said.
He said diversification can be a mixture of options, relative-value arbitrage and short volatility strategies that try to take advantage of the option premium, or volatility risk premium
“Each of these strategies can be used as an overlay in an investor’s portfolio and can serve a big purpose,’’ Bhandari said.
“The interesting thing about options is that trading them isn’t a zero sum game. Depending on how different participants use the same option in their portfolio…a buyer and seller of the same option may both win or lose at the same time.”
“What it does is [make it] desirable to trade a combination of these strategies and use options in different ways and use them as a diversified and diversifying return stream.”
He said investors should think about volatility not just a risk-seeking asset class but also as a diversifying and risk-reducing asset class.
“As well as a way to construct a unique return stream that can allow investors to engineer the profile that they’re looking for in this evolving market environment.”