Index access wrappers are an important consideration in the investment process. Once client want to go for a specific Trading Strategy Index (TSI), they have to decide in which form to access them. Traditionally a lot of institutional clients went for over the counter
(OTC) Excess Return Swaps or Total Return Swaps (on excess return and total return underlyings respectively). These are very flexible, but have become a bit less popular because of the involved credit risk and in some cases regulations like Dodd Frank
require reporting to the authorities.
Some clients are also worried about credit risk and may not be ready for the operational burden of running a credit support annex (CSA) with reasonably high frequency.
When deciding on a certain index access wrapper or vehicle, clients have to consider the following aspects:
Speed of set up
(Marginal) Cost of wrapper
Complexity of set up
- Regulatory limitations
Counterparty faced and quality thereof
Credit risk exposure to that counterparty
Mitigating factors on credit risk, such as CSA
Balance sheet costs (on the bank's side) which may affect pricing
Liquidity and potential penalty charges for early unwind
Possible alternative index access wrappers are medium term notes
(MTNs) or certificates, issued either by the investment bank or a third party issuer. They can typically accommodate any underlying that would otherwise be accessed through a swap; however these notes are not very handy in case the client wants to trade in an out of a certain underlying with ease and low transaction costs. Also, unlike doing swaps, MTNs and certificates require the client to put up cash upfront.
Some banks have set up a number of their TSIs as ETFs
. This allows investors to access strategies at very low transaction costs, negligible credit risk and balance sheet costs and great flexibility. On the other hand, if an institutional investor wants to make a sizeable allocation in more obscure strategies, the market maker in the ETF may not offer the whole size at the current offer price. Also, the client has to put up the capital upfront.
TSI set up as mutual funds share some of the features of ETF. Again low transaction costs (in the institutional share class), negligible credit risk and balance sheet costs and great flexibility are positive aspects. Bigger trades may lead to an increased tracking error until the fund provider manages to ramp up or unwind his positions to the new levels.
Setting up index access wrappers for highly flexible solutions is a bit more complex. Often a note is set up (typically SPV
issued) that has some resemblance to a managed account
or a portfolio bond. This note can be collateralised with high quality securities and could even contain a CSA
with the swaps provider. With such a set up the client can enter excess or total return swaps with the full flexibility of the OTC set up. None of the credit and potential regulatory issues arise. The obvious downside is the complexity and the set up costs of such a construct and the fact that it will typically only accommodate one swap provider/bank. So either the client has to get these flexible notes in place with a number of banks or face a limited choice and potentially reduced negotiation power in fee discussions.Also, unless a bank has created an easily replicable template for such a setup, this will involve lengthy negotiations and significant upfront costs. Banks will typically only go ahead with such a product if they expect significant repeated business and fees.
Naturally no one size fits all, so investor clients have to weigh their alternatives. One can always change the approach if the current one turns out to be suboptimal.