Gustaf Hagerud, Deputy CEO and Head of Asset Management, Third National Swedish Pension Fund (AP3).
We have had in-house equity management since the fund started in 2001. But then we primarily had exposure in the Swedish equity market, since we have a large exposure to that market. Internationally, in Europe, which is close to us, we have had both internal and external managers. In 2009, when we really decided to push for a strategy of increasing our index portfolios, we moved more management in-house. In this Alpha-Beta separation strategy all our large exposures in both the domestic and international equity markets were moved into low tracking error portfolios. These Beta-portfolios are either index tracking mandates or index-plus mandates. This is now the case for our holdings in European, North-American and Asian equity markets. European and North American Beta-portfolios are now run both internally and externally. In Asia, however, all exposure is taken within external index mandates. The time difference and the lack of detailed knowledge of Asian markets is the main argument for this decision.
If we have a system to manage the portfolio in-house, we can do it. And then it’s a matter of the performance we can get or expect to get in the portfolio, and our possibilities to actually access the markets. And, of course, we have large challenges in accessing emerging markets. But in Asia since it’s an index exposure, with no active decision-making, we could actually run this internally, but we don’t have to. And, of course, it’s a matter of just looking after the portfolio, understanding what kind of securities to run in the portfolio. So then we would rather use external managers.
The second stage of the Alpha-Beta separation strategy was to move all active portfolio management from traditionally actively managed long-only equity mandates, into internal and external absolute return mandates. The internal active management is now done in long-short portfolios with only risk allocation and no capital allocated. External active management is in the form of hedge funds.
One important reason to implement the Alpha-Beta separation strategy was a more efficient use of fees to external management. We have a certain amount that we can spend on external managers and we’d rather spend this on external managers that can give an absolute return, rather than on those giving us an index return.
Another motivation for the Alpha-Beta separation is that in-house management of Beta-portfolios simplifies quite a lot of what we do in our portfolio, in the sense that we can control exactly what we do with individual securities.
The right tools It is the proliferation of modern platforms that has given us the possibility to have much more of our asset management in-house. In 2009 we started a public procurement for an order management system that could improve our management of our internal Alpha and Beta portfolios. Our aim was to find an order management system that could be used for multiple asset classes, including fixed income, FX and equities. We also required a system where portfolio trades could be initiated by our internal Alpha-mandates and thereafter be taken care of by our execution desk. When the trades have been executed, they should go directly to our front-office and back-office portfolio systems.
It’s the order management and execution systems that makes this possible. We manage the portfolios electronically. The portfolio managers upload the portfolio every day from our back-office system, and they can execute directly through a broker or through direct market access. We use Bloomberg AIM for this.
It’s extremely easy for us. If it’s our European index portfolio for instance, we have our holdings in the system and we can see the index weights in our benchmark MSCI Europe. From the portfolio view in the system we can automatically create the trades that we want and after execution the trades will go through into our portfolio system. It is an extremely simple solution that we have.
We have only a few people doing the executions, as we don’t have enough resources to have an efficient algo desk. The execution desk managers take part in the management of our large internal index portfolios, and they also execute on behalf of our absolute return managers. The absolute return managers send their trades to the execution desk automatically through Bloomberg AIM.
We have used ETFs and still do, but to a smaller extent. For a large institutional buyer, it’s not efficient to use ETFs, since they are not cost-efficient for us. We do not find ETFs to be an implementation vehicle for any long-term allocation.
FIXGlobal speaks with the buy-side in China about the prospects for China’s equity market, IPOs and how new technology and competition will improve domestic trading.
GDP and Trading Volumes The property market might continue to cool down in 2012, but it is not reasonable to expect the Chinese economy to shrink significantly this year because the Chinese government will allocate resources to other sectors of the economy. Because of the Lunar New Year effect, it looks as though Chinese Consumer Price Index (CPI) is heading upwards. Based on adjusted CPI, the property asset bubble is a political issue rather than an economic one. The Chinese government has pledged to continue monitoring property prices, and its strong fiscal position gives them various options in terms of how they address this situation. Trading volumes are expected to be much the same as 2011 and inflation should be heading downwards.
Major Driver: IPOs or Economics? There has been a rapid increase in the number of IPOs in China, but the regulators are questioning the quality of some of the IPO companies. Of those companies newly listed in 2011, valuation declined quite significantly. Investors used to think an IPO was like a lottery – buying new shares virtually guaranteed a profit. Many investors did not consider the actual valuation and quality of the company, and many are now realizing that not all investments are worth their list price.
The Chinese equity markets are in a transition stage; they are moving from being somewhat amateur to being much more economic and investor-driven. There were instances of listed companies in one industry that changed industries after the IPO (often moving into property development) and occasionally changing the name of the company, leaving investors uncertain about their strategy and focus.
Listed companies used to have considerable power, but the market is changing in a positive direction. However, we do not know how quickly the market will become transparent and trustworthy. The regulators, media and institutional investors are now more serious about issues of valuation, transparency, corporate governance, etc. The regulators should consider increasing Qualified Foreign Institutional Investor (QFII) and ways of improving the dissemination of information to investors in order to set a good example in the domestic market.
A primary focus of the Chinese Securities Regulatory Commission (CSRC) this year is insider trading. Addressing this matter will improve the quality of listed companies and give investors greater protection. The regulators are working on improving access to information for investors and institutional funds will benefit significantly from this transparency. Regulators are concerned with addressing both the difficulty of access to information and the quality of information about IPOs, and it is quite likely that they will be able to improve both aspects.
Applying New Technology The biggest technology upgrade implemented in the past six months has been algorithmic trading. Most Chinese buyside use their brokers’ algos, but in China, domestic mutual funds are not allowed to route orders to brokers. So what many dealing desks have done is to install the brokers’ algo engine on their side, so for every algo they choose, they go through their server and send the order to the exchange. In this way, dealers achieve efficiency in their algo usage because they do not use any brokerage; as a dealer, they are almost like their own broker. Algo trading also provides the buy-side with more precise post-trade analysis; specifically, the ability to analyze how much alpha has been captured and the transaction costs involved.
The primary benchmark used by most Chinese buy-side traders is Implementation Shortfall (IS), which is used to generate information to help the fund manager improve their investment strategies. For example, it might provide data about the delay cost created by an investment decision made an hour after the market opens, showing the fund manager that if the decision had been made earlier they could have saved a certain amount on the investment.
Guosen Securities’ Shen Tao reveals the latest trends in algo usage by Chinese asset managers, domestic mutual funds and Qualified Foreign Institutional Investors (QFIIs).
Who are the primary customers for algorithmic products in China? Algorithmic trading started in the Chinese A share market some time in 2007. In 2005, the first commercial FIX engine went live to accommodate the execution needs of the Chinese A share market of Qualified Foreign Institutional Investors, or QFIIs, as part of the plan by the Chinese government to allow regulated capital market investment by foreign investors. After an initial experimental phase of FIX connectivity with global trading networks, the local FIX trading platform became solid enough to interface with a real algo engine. In 2007, some leading global investment banks (predominantly, QFIIs from the sell-side) began to offer algorithmic trading facilities for their clients and their own proprietary trading desks. Most of these facilities were located offshore (e.g. Hong Kong) and connected to the Chinese brokers’ FIX gateway via a financial trading network such as Bloomberg.
The earliest providers and users of algo trading in the Chinese market were solely QFIIs and their clients. In 2008, although the global market was in turmoil and many infrastructure budgets were cut across the international financial community, there were still some firms seeking expansion opportunities for the future. Among them, some global banks with local brokerage joint venture subsidiaries began to build their onshore algo facilities. At about the same time, some leading purely local brokers also started their efforts in algo development, Guosen among them. We started in March 2008 and also targeted QFII investors for algorithmic trading, however, we understood the future of algorithmic trading in the Chinese market would rest on the domestic mutual fund industry. In late 2009, the Guosen algo platform was almost ready and the aforementioned onshore algo facilities run by the sell-side joint ventures of global banks also went live. The day of the algo had finally arrived for China.
In 2010, with support from a leading buy-side OMS vendor Hundsun; Guosen and UBS began their efforts by offering an algo solution for local mutual fund companies. In November 2010, UBS won its first success with two Beijing-based mutual fund companies, with Guosen securing a third six months later. Since that time, more than a dozen mutual fund companies have started using algorithms from UBS and Guosen. 2010 was the first year of the algo, from a local perspective. Currently, the momentum of mutual fund companies adopting algo platforms continues. We estimate that by the end of 2011, in terms of assets under management, over 40% of the local mutual fund industry could be covered by broker-provided algo services.
In retrospect, QFII investors were the founders of the market, but soon, the local mutual fund industry will become the primary user of algos. In addition, we foresee insurance companies adopting algo trading soon.