The objective is to add value to the strategic asset allocation (SAA) – the neutral allocation or fund benchmark – within specified risk constraints, while preserving, over the long run, the integrity of the SAA.
TAA is a form of active funds management. A key statistic that is used to measure active management skill is the information ratio. It measures how efficiently a manager can convert active risk into excess return (alpha). The magnitude of the information ratio depends on manager skill and on breadth, where breadth is the number of independent active portfolio positions.
Driving taa evolution
The evolution of TAA has been driven by the desire to increase breadth and improve the information ratio. For example, TAA has evolved from domestic TAA, which involves equity/bond/cash decisions within one country to global TAA (GTAA). This involves creating a diversified portfolio of overweight and underweight positions across a wide range of equity, bond and currency markets.
TAA has also evolved in terms of how it is implemented. Decisions covering equities, bonds and currencies are now usually implemented using futures and forward-rate contracts. These derivative contracts provide a cost-effective and timely method of implementing strategy. This method also avoids the disruption to underlying asset-class managers that occurs if a TAA strategy is implemented in the physical market.
A futures contract involves the payment of an initial margin or deposit, which in turn buys an exposure to a market, usually about 20 times the value of the initial margin for the major equity markets and up to 90 times for the major bond markets. Each day as the market price changes, a variation margin is either paid or received by the owner of the contract depending on the direction of the market movement over that day relative to the positions held. To implement a GTAA program requires that funds are made available to pay for the initial and variation margins. Typically, this will mean allocating 3-4 per cent of the total fund to the program.
ACTIVE FUNDS MANAGEMENT:
The return objective for a GTAA program will vary according to client specific requirements. However, a typical objective would be to add 75 basis points (bp) to a fund per annum over the medium term. That is, the SAA of a fund might be expected to return 9 per cent, but with the GTAA program included it is expected to return 9.75 per cent. This objective can also be expressed relative to the 4 per cent cash made available to fund the program: if expressed in this manner the typical objective of the program is to make an annual return of 18.75 per cent (100 x 0.75/4.0).
The current evolution of GTAA has derived from the return objective being expressed relative to the cash required to run the program. The program can be packaged as an absolute return investment vehicle. An institutional fund might invest, say, 4 per cent of its assets in the GTAA vehicle (or a portfolio of GTAA vehicles) and if the objective is to make, say, 18.75 per cent per annum over the medium term then at the overall fund level this translates to 75bp.
Questions of design
The GTAA program should be designed to ensure that the manager is best able to achieve the desired objective for the fund. Two design questions to address are: what limits to place on the positions in the GTAA program; and what markets should be included?
Mandate or position limits are nearly always applied in mandates because they offer a level of comfort to clients and counterparties. How restrictive the limits are depends on the return objective of the GTAA program. As a general rule, the higher the return objective, the greater the limits.
Limits can vary across assets. Larger limits are usually applied in those assets to which the profit and loss (P&L) of the GTAA program is less sensitive. For example, the limits on bond markets are typically larger than those on equity or currency markets. Also the limit on the overall position of equities in aggregate relative to bonds in aggregate is typically smaller than the limits on country positions within equities or within bonds because the sensitivity of the P&L to the overall equity/bond position is high.
Limits should be symmetric: the maximum long (overweight) position should be equal in magnitude to the maximum short (underweight) position for each market. If the manager has equal skill in forecasting markets within an asset class then the limits applied to each market should be the same.
TGM has developed a sophisticated back-testing facility that allows it to run a GTAA program back in time using daily live data in an unconstrained manner. Limits can then be introduced, in discussion with the client, with the objective of minimising the impact on the information ratio.
Assuming the objective is to obtain additional risk-adjusted returns from the GTAA style of active management, the market coverage should be determined by what markets the GTAA manager is skilful at forecasting. These markets may not be the same as those in which the fund has physical investments.
There are two ways in which a fund can invest in a GTAA program: through a GTAA managed account and through a GTAA pooled vehicle.
Investing via a GTAA managed account involves a GTAA program tailored to the specific requirements of the fund. TGM has been setting up tailored managed accounts for institutional investors around the world for the past eight years. The minimum amount required to run a GTAA managed account depends on the target return objective of the account. As a guide, a minimum of about $10m would be required to run a GTAA managed account with a return target of, say, 18.75 per cent per annum. The impact that investing in the GTAA program has on the overall return to the investor’s portfolio depends on the share of the portfolio that is invested. For example, to achieve 75bp at the portfolio level, the institution would need to invest 4 per cent of its assets (0.75 per cent = 18.75 per cent x 4 per cent).
A GTAA pooled vehicle is a specialist investment vehicle designed to achieve a return in excess of cash from GTAA. It would be particularly well suited to small portfolios, for which the lumpiness of futures contracts makes the precise implementation of GTAA strategy difficult. By pooling, a GTAA fund can become large enough for the GTAA strategy to be implemented in a more precise manner.
Program funding
The next issue to address is how to fund an investment in a GTAA program. The nature of the underlying instruments that are used to implement the strategy provide a lot of flexibility. Although cash is required for the GTAA program, that does not mean that only portfolios with an SAA with a cash benchmark weight of that investment size or more can invest in it. For example, a portfolio may have a zero benchmark in cash and fund GTAA out of the bond allocation. The GTAA manager can then convert the cash invested in the GTAA program back into a bond exposure using futures contracts. This is sometimes called an equitisation overlay.
In addition to an equitisation overlay to preserve the SAA when funding the GTAA program, TGM can provide a rebalancing service to maintain the continuity of the SAA due to market movements, cash flows or any event that might cause the underlying investments to deviate from the SAA. A rebalancing overlay will usually be run separately to a GTAA program.
Different rebalancing protocols can be used, for example, time, distance or a measure based on a portfolio threshold effect. The time protocol involves rebalancing at set time intervals, such as once a quarter. The distance protocol involves rebalancing once the portfolio deviates from the SAA by a set amount. The threshold protocol involves rebalancing once the portfolio deviates from the SAA according to an overall portfolio measure of the difference.
New TGM GTAA vehicle
TGM has launched a GTAA pooled vehicle called the TGM Directional Fund. The target return is 12-17 per cent in excess of the cash return over the medium to long term and, like all of TGM’s products, the fund offers daily liquidity.
The TGM Directional Fund is based on an existing GTAA fund that has been running for the past two years with more than $80m under management. TGM manages $17.5bn in total with eight years of experience in this area and has institutional clients in Europe, North America and Asia Pacific.
TGM’s investment philosophy is that relative market movements are driven by economic fundamentals. The firm identifies mis-pricings in asset markets by using an integrated global modelling system that captures the interdependencies between asset markets and other markets both within an economy and between economies.
TGM makes conjectures for the economies it is forecasting which, together with the latest data releases, are used to drive its global macroeconomic and financial market model to produce forecasts for the major equity, bond and currency markets. These forecasts are used as inputs, together with the current daily prices, into TGM’s sophisticated risk management tool.
An important part of TGM’s philosophy is that, once its forecasts have been set, it uses its risk management tool to actively monitor the markets and to refresh the investment strategy each day.
In conclusion, GTAA is an important source of uncorrelated returns that is a far simpler concept with greater transparency than is often reported. It has developed over the past few years where there is greater flexibility in funding and product design. The differing styles of GTAA management allow even greater diversification for investors, where TGM represents the fundamental economic style.
Dr Peter Higgs is managing director of TGM
(www.tgm-global.com)
