A useful tool, but handle with care
Pension fund trustees increasingly agree that derivatives, used correctly and with adequate controls, can provide benefits to their funds by lowering costs and allowing for the efficient implementation of investment strategies. At times, they can also boost performance and lower risk.
Paul Myners, chairman of Gartmore Investment Management, suggests that the blanket bans on derivatives contained in the trust deeds and rules of some pension funds are unhelpful. He made the comment in his March 6 report to the UK government on institutional investment.
“It appears to be based on a belief that derivatives are so inherently risky that a trust must be prevented from using them in any circumstances,” he wrote. “In reality, of course, derivatives can be used to reduce as well as to increase risk.”
Trustees and fund managers have many varieties of derivatives to choose from. Among the investing instruments covered by the term are futures, options and swaps. Structured notes and collateralised mortgage obligations are often referred to as derivatives as well. A derivative generally is defined as “a financial instrument the cash flow pattern of which is directly linked to the performance of a referenced underlying instrument or index”. Essentially, the performance of a derivative derives from the returns of the underlying instrument.
Generally, trustees are becoming more comfortable with their use, even though derivatives are associated, justifiably or not, with well-publicised financial debacles. They got a bad name after Orange County, California, suffered $1.6bn(e1.8bn) in losses in December 1994, the result of adverse changes in interest rates and high leverage created in part by using derivatives. Another dent to the image of derivatives came when Bankers Trust settled a derivatives-related dispute with a Pennsylvania chemical company for $67m in 1996. Probably the clearest case was that of Britain’s Barings, which collapsed in February 1995 after a rogue trader took futures positions that broke the firm.
The result was that derivatives became associated in the minds of some trustees with an inherently high degree of risk. But, as Myners noted, such an association is not appropriate. Benefits from derivatives can be obtained without taking any more risk than managers normally would take investing in other instruments. Indeed, the risk factors between derivatives and traditional investments are identical. Used correctly, derivatives can offer benefits without taking on additional risk.
Although useful, derivatives can be complex instruments and trustees should exercise control and supervision over their purchase by managers. The degree of trustee involvement depends on the strategy being followed. When systemic problems are involved, trustees should become more closely and directly involved in the process.
Indeed, Myners proposed that trustees should have a legal requirement to be familiar with the issues when they take investment decisions.
The cardinal rule is to take no risks using derivatives that would not be prudent using the traditional investments from which they are derived. Trustees should use the same standards that they would use when assessing the risk elements of the underlying investments to determine the degree of risk to which they are exposing their funds by using derivatives.
Trustees should not assess derivatives using accounting measures such as their face value and the number of contracts involved. Two futures contracts with the same face value, or two swaps on the same notional amount, may pose markedly different risks. Trustees should focus instead on the degree of risk exposure the investment represents.
Many tools are available to help manage the degree of risk. Trustees and managers alike should use them to increase their comfort level in the use of derivatives as well as in the use of traditional instruments.
Trustees should ensure that such risk measurements are undertaken before fund managers invest in the derivatives themselves. Derivatives package familiar risks in unfamiliar packages and degrees of concentration. They can be extremely complex. Buying derivatives they cannot fully analyse is a common, but unforgivable sin, among managers and trustees.
Once trustees ensure that the risks of all derivatives they consider using can be measured, a single set of risk-based guidelines can effectively regulate the use of both traditional securities and derivatives under a single umbrella.
Managers who use derivatives effectively tend to pursue a number of simple and straightforward strategies.
A common strategy called ‘cash equitisation’ uses derivatives to put cash to full advantage while the trustee is holding it for later investment. Holding the cash creates ‘cash drag’. The purchase of a combination of stock index futures and an underlying cash investment can be used by a pension fund to maintain an effective 100% exposure to the equity markets, equivalent to the exposure that would be obtained were the cash fully and immediately invested. While it is equitised, managers can work to reinvest their cash on their own timetable.
Some investment managers have used this approach to create products that earn an active return through management of cash but represent a strategic exposure to equities. These managers actively invest a traditional cash portfolio and buy stock index futures contracts to establish a strategic equity exposure. The combination of returns from the cash position and the futures contracts will mirror the returns earned by holding a traditional position in an equity index fund, while providing excess returns from active cash management. The managers claim that the excess returns that result are more stable than those available from direct active management of equities.
Derivatives also can be used to create synthetic, higher-returning substitutes for traditional securities that trustees would otherwise hold. Opportunities to do so typically arise when hedgers push down the price of a futures contract relative to the underlying security.
A benefit of using derivatives in a pension portfolio is that trading costs are lower compared with the underlying assets. For example, transacting in stock index futures is less costly than establishing a position in the underlying stocks themselves, particularly if the change in desired exposure is temporary rather than permanent.
On the downside, unfamiliarity with derivatives can lead managers to take more risk than they should be taking. If they are not acquainted with the strategy and the timing required, they can get in over their heads.
Liquidity risk varies widely. Some derivatives, such as futures contracts, exchange traded options, many over-the-counter options and some collateralised mortgage obligations, are highly liquid. But liquidity is reduced during distressed market conditions or when the instruments become more exotic and more specialised.
Liquidity risks are controlled through the establishment of investment guidelines that delineate the types of investments that are permitted in a portfolio or fund, diversification requirements and the availability of independent pricing.
Another drawback occurs when fund managers use derivatives for purposes other than transient strategies. Over longer periods, futures and options positions expire and must be rolled into new positions. The cost of re-establishing expired futures or options positions can grow over time to exceed the cost of a single adjustment of the underlying portfolio.
By not permitting the use of derivatives in their pension plans, trustees could be ignoring a valuable aid to efficient investing. But they should ensure that derivatives are subject to the same controls, guidelines and risk exposure that apply to the underlying investment instruments.
George Oberhofer is senior practice consultant with Frank Russell Company in Tacoma, Washington