By Margaret Elliott
At CDC Investment Management, derivatives are integral to every process, especially those big-cap equity and G-7 bond portfolios.
There comes a time in every economist's life when simply forecasting the future isn't enough. You want to flex your muscles, try out a few of those tricks of the trade. For Bluford Putnam, president of CDC Investment Management Corp., the investment management subsidiary of the French public trust institution Caisse de Dépôts Group, that day came later rather than sooner. After 15 years of being an international economist for Chase Manhattan Bank, Morgan Stanley and Kleinwort Benson, Putnam decided that he wanted to manage money rather than advise clients on what to do.
It was a good moment to take up the challenge. Academic work on markets and investing was put to the test during the stock market crash of 1987, and the trading desks of Wall Street were filling with Ph.D.s in economics, mathematics and physics. But few breached the conservative world of money management, where derivatives can still be thought of as a dirty word.
"Derivatives can be an appropriate way to go from A to B, if you decide to go from A to B,” explains Putnam in his rational fashion. He has no problem with the cash markets, but experience has taught him that derivatives can be the cheapest and most efficient way to execute investment decisions in many cases.
CDC Investment Management, which Putnam joined last year, was formed in 1991. At that time, not surprisingly, the firm invested in fixed income and had only European clients, with a preponderance of French institutional money. After the five-year mark was reached in 1996, and with all the changes due to occur in the European markets, Caisse de Dépôts made the decision to expand both its product range and marketing efforts. Putnam came on board from Bankers Trust Investment Management, where he had been chief investment officer for equities. At CDC Investments, he has a mandate to build the business in the United States and North America, as well as expand he scope of products.
Nothing moves quickly in money management, but Putnam has brought on some large U.S. clients that account for CDC's $2.5 billion of performance-based hedge funds under management, up from $1.7 billion when he joined. But most important, he's expanded the range of products to include global asset allocation products and a U.S. equity portfolio, to complement the existing mortgage and global fixed-income products.
Many of CDC's European clients arrive with the need to enhance the yields they receive in their fixed-income portfolios. "But they don't want to take a whole lot more risk. They are comfortable with the risk level of fixed income. But what do you do?” asks Putnam. "From our standpoint, we give them a product that has controlled volatility, so they are getting the risk they are comfortable with, but they get the excess returns from some totally different source from that available domestically.”
As an example, Putnam describes a typical CDC mortgage-backed portfolio. "A normal portfolio of mortgage-backed securities comes with many risks: interest rate risk and prepayment risk (and dollar risk if the client isn't dollar-based). And it comes with complexity. We get rid of the interest rate risk so that it will be comparable to the short-term portfolio of fixed-income instruments that most corporate or pension fund clients are used to. We use futures to remove the directional interest rate risk. For clients who want to strip out the foreign exchange risk, we lay on a currency swap or a forward transaction to get the portfolio into French francs or Deutsche marks. Then we look at the prepayment risk and decide how much of that we want to hold.”
Technically, the execution of a portfolio with just the kinds of risk CDC wants to hold can be complex. "We look at some pretty fancy mortgage structures, like the IO and PO markets, when we are trying to isolate prepayment risk. But it allows us to be long a part of the mortgage market we think is cheap and short a part we might think is expensive, when we think the prepayment risk on the instruments is similar,” explains Putnam.
The other ingredient in the mix is leverage—to some a dirty word. And it's not the only bad word in Putnam's portfolio. "Every one of our portfolios has leverage, and 98 percent of our clients pay performance fees,” he says unabashedly. "All these tools help us get rid of the risk we don't want to take. In this mortgage product, we construct securities you can't buy anywhere else and are able to produce a source of return that is not correlated with what you would get in your normal market. Remember, the client can choose the risk level and the leverage level. Our low-risk version shoots for LIBOR plus 150 basis points; our highest aims for 12 percent to 15 percent a year total return and is leveraged 10–15:1.”
Another bond-based strategy CDC offers is called global dynamic asset allocation. It works as follows: the client picks a risk level it is comfortable with, expressed as, say, the risk of a 10-year French bond or a 10-year German bond. Putnam's team is able to use currency and fixed-income futures to create a global portfolio that produces the same risk level, but doesn't correlate too highly with the portfolio the investor already has. "We execute this strategy by buying and selling the futures, never by buying the cash. The transaction costs in the cash are higher and it is more difficult to move the portfolio around,” explains Putnam.
The CDC global product, a new one to the range, uses two levels of derivative products to produce a risk and return level on the overlay that is not correlated with the underlying return of G-7 markets. The bottom level would be long G-7 equity index futures; the overlay is a global futures portfolio that would meet the risk and return parameters set by the client. "We can execute this kind of strategy on any underlying. We take what is essentially an S&P 500 stock portfolio and we try to get you, say, 8 percent to 10 percent above the S&P 500 return. That additional yield is designed not to correlate in a directional sense with the large-cap U.S. equity market,” says Putnam.
CDC doesn't use the typical approach to buying a portfolio, international or domestic, where limits are placed on such things as what percentage of the portfolio can be exposed to a given country—partly because the execution uses futures and not the underlying, and partly because CDC doesn't define risk in that way. "We would identify the target risk of a portfolio as a 6 percent standard deviation, or a 12 percent standard deviation. In a low-risk portfolio that might be a 3 percent standard deviation,” says Putnam. (By that he means the risk that the returns might not reach the target level, or in fact exceed the target level.) A 3 percent standard deviation risk means that there is a 65 percent chance that the return will be within a 6 percent band that is plus or minus 3 percent around the target return level.
Putnam, being a long-time risk manager, is not a fan of value-at-risk, at least in the way it is practiced today. "Standard VAR relies on historical data, and history is a bad predictor of risk,” he says. "We are not slaves to historical VAR. We produce what is theoretically a VAR analysis, but we get there using different data sets. We believe to a certain extent that risk is mean-reverting. So a key element in our risk management models is a judgment process. We choose five or six key variables for each market and add our own judgment.”
It is this willingness to address the one issue that most risk managers won't touch—forecasting risk—that sets Putnam's approach managing money apart from that of many of his peers. "In most companies, particularly banks, the risk management team has never earned any money. It's a cost center. Our risk managers are embedded in the portfolio and they are responsible for earning a high Sharpe ratio. If they get rid of all the risk, they get rid of all the return and they won't earn a bonus.”
Although Putnam has shed the academic economist's mantle, he hasn't lost his zeal for forecasting. Only this time he expects it to pay money as well.