Superannuation funds should bypass “black box” for alternative investments, says Parametric
Raewyn Williams
The US-based implementation fund manager, Parametric, has devised an alternative source of return that will allow APRA-regulated funds to bypass hedge funds.
Tom Lee, Managing Director Investment Strategy and Research, and Raewyn Williams, Managing Director – Research (Australia), have launched a new research paper prompted by superannuation fund trustees becoming uncomfortable with opaque ‘black box’ hedge fund structures, but needing a way to access hedge fund-like alternative returns.
The research paper shows how these superannuation funds can use an alternative risk premium to generate a return that is more “transparent and systematic” than hedge fund strategies.
The alternative source of return, known as the Volatility Risk Premium (VRP), exploits a characteristic in equity option markets both in Australia and overseas where option buyers (buying volatility protection, including many superannuation funds) seem to consistently overpay option sellers (selling volatility protection), relative to what the protection is actually worth (measured by actual realised volatility).
The paper summarises why this premium exists and why it is likely to persist in option markets.
Lee and Williams say APRA-regulated funds typically invest in option markets to buy protection or upside participation, paying an expensive price for these option premiums.
“We argue that more funds should be on the sell side of these option transactions, and that many funds fit the profile for a natural option seller, not buyer.
“By becoming a seller rather than buyer, the fund can receive as an income source, rather than pay away as a cost, the VRP. Funds should exploit their ability to be on the more lucrative sell side of these transactions.
“Once a fund makes the decision to be a seller and harvest the VRP, they don’t need a ‘black box’ hedge fund to implement this strategy.
“The portfolio we designed strips away the trust structure, designs straightforward implementation rules and follows these rules in a systematic, repeatable way. It is also liquid, contains no leverage and is fully collateralised as a self-contained solution for a fund.”
They say most APRA-regulated funds use hedge funds to diversify risks away from equities and fixed income, but hedge funds are causing difficulties in two ways.
“First, their returns have been low in recent times, a problem made worse by high fees and tax inefficiencies. Second, they are typically opaque ‘black boxes’, meaning the exact nature of their strategy, complexity, risks, etc, aren’t visible to trustees. Although the first is market related and could turn around, the second problem is structural and cannot be wished away.”
APRA-regulated funds typically only have about 2% of their portfolios allocated to hedge funds, but the risks inside the fund could be higher.
“Increasingly, APRA-regulated funds are unwilling to just trust the ‘black box’. Transparency is an industry trend – not just in Australia – and regulators are mounting pressure on trustees to know exactly what sits inside their portfolios.
“In response, super funds need to find a way to access the diversifying, alternative sources of returns that hedge funds offer in a way that supports ‘simplicity rather than complexity’ and ‘transparency rather than a black box’. Our solution is a portfolio of no surprises, performing as expected through different parts of the market cycle.”
