“Opening the Black Box” is our ongoing series on the data treatments, assumptions, and methodologies behind our analyses. In this series, we answer frequently asked questions on how we build, validate, and make decisions about our data.
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In our last blog, we looked at how CEM measures the asset base behind every cost ratio, including a first look at how leverage should be reported on the survey. This post goes a step further. We look at implicit and explicit leverage, how the two are treated differently, and how our benchmarking adjusts for explicit leverage so that a levered fund is compared consistently to its peers.
Defining two types of leverage: explicit and implicit
At CEM, we factor two types of leverage into our benchmarking: explicit leverage and implicit leverage. Our approach is different for each type.
Explicit leverage is borrowing that shows up on the balance sheet and is used to increase economic exposure to an asset class. Among our subscribers, repo financing is the most common source.
For example, a fund might enter a $50 million repurchase agreement (repo) and receive $45 million in cash. The fund may then use that cash to deploy $45 million in additional capital across the portfolio, for example, to adjust asset-class targets or to take advantage of an opportunity through tactical positioning.
Implicit leverage is economic exposure gained synthetically, typically through derivatives. Risk parity and portable alpha strategies often employ implicit leverage.
For example, a fund with $100 million wants to retain its S&P 500 exposure while seeking alpha through a hedge fund strategy. The fund uses $10 million as collateral to obtain a $100 million S&P 500 exposure through equity futures, while it invests the remaining $90 million in a hedge fund strategy designed to generate alpha. The implicit leverage through equity futures will be reflected under derivatives, along with the associated cost.
Reporting explicit leverage
When funds use explicit leverage, we track it in both policy and actual asset allocations, where applicable. Cash assets are decreased by the gross leverage and offset by an increase in other assets in the portfolio. Leverage should be reflected in the policy allocation when it is part of the fund’s policy.
We also include the investment management costs associated with leverage, including the costs of any team members overseeing the program, as a cost at an asset-class level.
The financing cost of leverage, such as the interest paid on borrowing, is not classified as an investment management cost. Its economic effect is reflected in investment and policy returns, as the financing cost represents the return owed on the short position (in cash or bonds).
For example, say a fund receives $1 billion through repos to commit additional capital to third-party private equity managers. The fund would report $1 billion as negative cash and report private equity holdings inclusive of the additional $1 billion. The additional investment management costs would be included in cash.
Hence, if explicit leverage is part of a fund’s policy, it should also be reflected in the policy allocation. For example, 60% stocks, 30% bonds, 20% private equity and -10% cash.
Reporting implicit leverage
Leverage embedded within third-party managers’ portfolios does not need to be separately identified. Asset-class NAVs should be reported net of that leverage. However, the derivatives or overlays used to create a synthetic economic exposure must still be reported, along with their costs.
CEM benchmarks derivatives and overlays as a total fund implementation choice. The cost impact of using more, or less, overlays than peers is reflected in the fund’s total cost position relative to the benchmark.
How leverage flows through the benchmark
Below, we walk you through an example of how CEM’s benchmarking methodology accounts for the use of explicit leverage.
The starting point
A sample fund has $60 million of public equity costing 55 bps (i.e., $330,000), and $40 million of fixed income costing 30 bps (i.e., $120,000). Thus, the fund’s total assets are $100 million with a total cost of 45 bps (i.e., $450,000).
The fund is being compared to a peer group with a median cost of 65 bps for public equity and 28 bps for fixed income.
CEM calculates the benchmark cost for the fund by adding the peer costs to implement public equity of $390,000 (i.e., $60 million x 65 bps) and $112,000 (i.e., $40 million x 28 bps). This results in a benchmark cost of $502,000 or 50.2 bps, which is $52,000, or 5.2 bps, above the fund’s actual cost.
Adding leverage
Now let’s assume the same fund takes on $10 million in explicit leverage and allocates it to additional fixed income. For simplicity, let’s assume the cost of managing the leverage is 0 bps, as the internal management costs are typically de minimis.
The fund’s costs now rise to $480,000, or 48 bps, as the fund is managing $10 million more fixed income at a cost of 30 bps.
But the benchmark scales accordingly. Because the benchmark is built based on the fund’s actual holdings, the benchmark now reflects the larger, levered fixed income allocation and rises to $530,000, or 53 bps, which is the additional 28 bps peer median (i.e., $28,000) on the $10 million leverage. The fund’s total cost is now $50,000 or 5 bps below the benchmark.
Therefore, the fund’s relative position to the peers remains essentially unchanged. The fund is still below benchmark cost. Even though the fund’s costs have gone up from 45 bps to 48 bps, its relative position remains about 5 bps below the benchmark cost. There is a slight reduction in how much below benchmark the fund is because fixed income, where the fund has a small cost disadvantage relative to peers, now accounts for a larger share of the portfolio.
Importantly, one fund’s use of total portfolio leverage does not directly affect other funds’ benchmark costs, because our peer benchmarks are based on asset-class management costs rather than portfolio-level financing costs. We will walk through an example of our benchmark cost model in more detail in an upcoming blog.
Our committment to you
The trust our subscribers have placed in us over the years, many for close to a decade without interruption, is something we take seriously. This series is one way of honouring that trust. We are not here to simply explain ourselves. We are here to open a dialogue that pushes our work, and the industry, forward.
We look forward to hearing from you. If there is a question you would like us to address, please reach out to us at insights@explorecem.com.
This blog is part of our “Opening the Black Box” series. If you’d like to receive new posts in your inbox, please click here to subscribe.