Pension funds across Europe have spent much energy reconsidering asset allocation. The introduction of the euro has been a driver for major changes over the past few months. Generally investors focus their energies on deciding how much to allocate to each asset class and when to make decisions on reallocations within their portfolios. The decisions are often complex, and influenced by factors ranging from actuarial advice to long term investment considerations.
However, these decisions are frequently implemented in a less sophisticated manner. In many instances the way in which broad asset allocation decisions are translated into changes in investment holdings runs the risk of incurring high costs and being slow to achieve target holdings objectives. Below I outline two increasingly common ways of using derivatives that many pension funds have found beneficial when making asset allocation transitions.
Often a pension fund board or asset allocation committee will decide that the portfolio asset allocation should change rapidly. The portfolio managers, however, may need time to select which stocks or bonds to buy or sell. Fund managers may also consider that some holdings should be held for some weeks or months more, and may be unwilling to sell them immediately.
Using a “futures overlay” is a way of satisfying both objectives. Futures are bought and sold to achieve an instant shift in asset allocation and then, over time, as portfolio managers complete stock or bond trades, the futures positions can be unwound.
European equity futures are generally several times more liquid than stocks, and commissions are very low when compared to stock trading. As a result, using futures can avoid potentially costly and hurried stock trading decisions.
In addition, futures positions can be converted into complete stock portfolios through “exchange for physical” trades. Here, a fund manager provides a broker with some basic characteristics of the desired portfolio (including countries, liquidity, risk relative to an index), but does not reveal names until after the close of trading. The broker quotes a commission based on the basic characteristics, and after the market close, buys or sells stock to the client at the closing prices, and receives the futures. The fund manager has no market impact – the broker sells names out of inventory at prices that were fixed before he knew what names would be traded. Often brokers quote low commissions for these trades as they involve low levels of risk for the broker as well as the client.
Recently, some institutions in Europe have started to use options to capture value from investment decisions. For example, if a pension fund knows that in three months’ time it will need to increase equity holdings, then it can receive payment today for committing to buying more equities in three months’ time. This is done by selling put options on equities.
To take an example, if ABC has been told by his asset allocation committee that in three months he will need to increase his holdings of European equities, then he can sell put options on an index such as the Euro STOXX 50. With the index at 3,683.34 today, he might sell put options at 5% below today’s levels (or an index level of 3,500) with three month expiration on underlying value of e10m. This is equivalent to committing to buy e10m of equities at 5% below today’s levels in three months’ time, if the buyer of the option requires you to do so. For this he would be paid 3.25%, or e325,000 at current option prices.
If in three months’ time the index is above 3,500, the options expire worthless. The investor has received income of 3.25% and is free to do what he wishes. If the index is below 3,500 he will be required to buy stock at 3,500. This in many ways reflects an investor’s natural behaviour – he might naturally be inclined to buy stock in three months’ time at below today’s levels. He might also hold off from buying if the market had risen significantly. Importantly, however, he is paid at the outset for making a commitment to buy stock that might not seem too onerous given the requirements of the asset allocation committee.
The major risk for the investor here is that the market falls very sharply – in this case he will still be required to purchase stock at 3,500. One way of reducing this risk is to buy a second put. For instance, if the investor purchased a put with strike 3,000 then this would give protection that the lowest price the investor would be required to buy stock would be 3,000.
A recent extension of this idea has come from European investors who are looking to shift asset allocation from domestic to pan-European over time. These investors have sold calls against domestic stock positions, and sold puts against foreign stocks that they would like to hold. Although a full analysis of this is beyond the scope of this article, the net result is an asset allocation shift over time. As domestic stocks rise, the investor sells them, and as non-domestic stocks fall the investor buys them as a result of this strategy. In essence, the investor receives premium income from selling options against a future investment decision.
Both of these uses of derivatives have been identified by pension funds as making asset allocation changes more efficient. The first will reduce trading costs and increase the speed with which asset allocation decisions are implemented. The second allows investors to receive income for committing to future investment decisions, often not an onerous commitment because it fits well with asset allocation targets.
Sandy Rattray is executive director, equity derivatives research, Goldman Sachs International in London