Attitudes are changing
Pension funds are beginning to use derivatives more and more, particularly for asset allocation purposes, hedging their positions and portfolio transitions. Though the use of derivatives is now more common in the UK and the Netherlands, their use across Europe appears to be gaining acceptance. Trevor Robinson of Trevor Robinson Investment Management, a London based independent consultancy firm specialising in pension funds and derivatives, says that while the majority of his clients are UK based, the philosophy behind the use of derivatives by pension funds remains the same across Europe. “Most of my clients are in the UK. I have clients in Austria and Switzerland and hope to have others elsewhere soon. But the advice sought and the reasons for using derivative instruments are identical regardless of geographic location.”
Stephen Ashworth, senior managing director of consulting at Reech Capital in London, a derivatives and risk management specialist firm, says that pension funds are one area that he is keen to move into. “Pension funds are increasingly showing an interest in derivative products.” Reech Capital’s client base comprises 40% across continental Europe as opposed to 10% in the UK.
Robert Coomans, co-ordinating funds manager at ABP, the pension fund for Dutch civil servants with €150bn under management based at Heerlen, confirms that they are not shy of using derivatives, so long as the purpose is understood. “If used speculatively, then I can understand why people fear them. We (at ABP) use them solely as an instrument for asset allocation and hedging purposes. We have used them for quite some time now and really quite successfully,” he says.
In Denmark, regulatory changes hold the key for greater integration of derivatives into pension funds. “At the moment Danish pension funds don’t generally use derivatives, but they will become more popular as tax reforms come into force,” says Troels Gunnergaard, chief investment officer at PKA in Hellurup, Denmark’s largest pension fund administration company with DKr 71.1bn (€9.5bn) under management. He says that reforms introduced last year were already beginning to have an effect on the derivatives market.
However, derivatives is a generic term that needs to be broken down before a true picture about their use can be established. Roy Peters, chief executive of Aerion Fund Management in London, the pensions fund arm of British Gas, says that certain types of derivatives products are more popular than others. “Derivatives based on mainstream equity and bond markets are now regularly used by pension funds.” Indeed, he believes that large pension funds cannot implement asset allocation changes or restructure their portfolios without using derivatives of some kind. “Because of their size, smaller funds may be able to use the physical market but larger funds cannot.”
Gunnergaard agrees that the way derivatives are defined is essential in gauging the extent to which they are used. “It all depends on your definition of the term,” he says. “Currency futures and convertible bonds are already used extensively in Denmark, but more refined instruments such as options are less common. And futures are used more on stock markets.” He suggests that the use of derivatives also fluctuates depending on market conditions and timing.
ABP uses a wide range of instruments. “We use futures, currency swaps, interest rate swaps, and options, though in a more limited way,” confirms Coomans. He says using derivatives when investigating asset allocation strategies is easier than starting off with the underlying physical stock.
Ashworth of Reech says that his clients generally start by playing safe. “Pension funds generally go for listed products to begin with, because they can keep a track of them.” However, these do not give managers the structure they are looking for in terms of risk and reward. “The more sophisticated funds get involved with OTC structures, yield enhancements, selling upside calls, reverse convertibles and basic derivatives trading. These factors combined with basket type trading are designed to diversify risk. Derivatives are all about managing risk and should be used basically to tailor the risk within your portfolio.” Exotic option features are sometimes also added to help keep costs down.
Robinson says that managers basically go for futures contracts as part of asset allocation. But he believes that there is one essential difference between the UK and continental Europe. “It is interesting to note that in the UK, derivatives are used more widely in fixed income portfolios than in equity based ones. This tends to be the other way round elsewhere in Europe. This may be because there is more of an equity culture in the UK or that continentals are more concerned with the downside of equities.”
Though no real legal restrictions have prevented pension funds from using derivatives in the UK, trustee deeds and regulations of individual funds have nonetheless played a part in hindering their growth.
“Pension funds are historically conservative bodies and lack the expertise to effectively include derivatives in their portfolios,” says Ashworth. “But this is slowly changing, and as such we are putting together full training programmes as well as offering technical assistance as an application service provider.” This means that pension funds will be able to calculate futures and options contracts online without having to buy expensive software or invest in new systems.
Robinson says:“Turning to technology, many software packages used by fund managers do not report derivatives in a meaningful way. This means that trustees do not always have the correct understanding of their potential impact - for good or bad - on their portfolios. We have developed our own software to overcome this problem.”
Tony Watson, chief investment officer at Hermes Pensions Management in London, which manages assets in excess of £50bn (€81bn) says that Hermes has never been shy of using derivatives since it does not use them speculatively. “We have used them for years and years. We are not inhibited about using them since we use them to enhance returns and not for speculation. Part of the problem lies in trustees lack of understanding. Trustees fall short of implementing derivative strategies because of past disasters. But it needn’t be that way. Our portfolios are not geared through derivatives.”
Robinson agrees and cites the Barings crisis as a major stumbling block but that young blood is now helping to educate trustees in the UK. “The Barings crisis gave futures a very bad name. It’s not a question so much of restrictions but more of cultural baggage. Derivatives should be seen as just another tool and shouldn’t come to dominate an entire portfolio. But things are changing as junior fund managers in favour of increased use are having an influence on more traditional trustees. They generally understand the risk parameters better. They are succeeding in getting across a message that consultants have been pushing for years.”
The future looks promising. ABP says that developed countries dominate the futures market at the moment but that will change. “Liquidity among futures is set to increase as emerging markets, such as Mexico, begin to grow and use derivatives more,” says Coomans.
Peters at Aerion would like to see the development of more property based derivatives. “This will bring property into line with other asset classes and facilitate asset allocation changes” he says.
Robinson feels that it will be interesting to see how the culture surrounding derivatives evolves. “Some years ago doors would have been closed in your face at the mention of such a thing. Now pension funds are beginning to dip their toes.”