How to stop dreading a D-word
What’s in a word? Too many associations, perhaps. A prominent economist once described “derivatives” as “the only four-letter word with 11 letters”.
For many UK pension scheme trustees, the d-word evokes strong associations with a certain Mr Leeson. Of increased risk, rather than a sophisticated way of managing and reducing financial risk. According to the most recent National Association of Pension Funds (NAPF) survey around a third of UK pension schemes still prohibit their fund managers from using derivatives. This is a source of frustration from those keen to make the most of derivatives who feel they are battling against a rather irrational fear.
A starting point is to look at how derivatives products are already used successfully by pension funds. In 1998, our firm carried out a survey of UK fund managers to assess how widely and for what purpose fund managers use derivatives.
The results (in the chart) seem to tie in with the NAPF survey. However, perhaps in their responses to that survey, trustees didn’t associate the d-word with currency hedging, which is used routinely to reduce the risk of currency fluctuations when investing in overseas bonds and equities. They may also not appreciate that passive or index-tracking funds often use index futures. In particular they are used to make cash holdings behave in line with the equity index that they are tracking. This “equitising” of cash is useful in reducing transaction costs when the fund may need the cash at short notice to pay benefits.
Switching cash into equities is one example of the use of derivatives by investment managers for asset allocation purposes. Moves from one asset class to another can be implemented relatively cheaply and efficiently. This is helpful if the investment manager wants to make a tactical move from one asset class to another for a short period. This approach can also be used if the manager is implementing a longer-term strategic reorganisation in the portfolio but wants to take his time in buying and selling the precise stock holdings. He can use futures to make sure that the portfolio will behave roughly in line with the new strategic asset mix over this period.
The actuarial profession and several fund managers are keen to explore more adventurous uses of derivatives to act as a form of insurance against funds’ investments and liabilities moving in different directions. At the Institute and Faculty of Actuaries’ Investment Conference in May this year, the profession considered a paper called “Derivative backed protection strategies for pension funds”.
This paper showed how pension fund trustees or the sponsoring employer could use derivatives to manage various risks including the possibility of failing to meet the Minimum Funding Requirement (MFR) or having unpredictable pension costs in the company’s accounts. In the past, trustees have managed these risks by relying on having a scheme surplus to cushion the shocks, a strong employer who can meet the payments, or actually changing asset allocation to obtain a better match between assets and liabilities. With surpluses reducing and conflicting funding objectives pulling asset allocations in different directions, using derivatives has become more attractive.
To make the most of this potential, the main bridge that has to be built is one of communication and understanding. Investment consultants need to be fluent in the language of derivatives so that they can translate options such as puts, calls, spreads and collars so that the price paid and the risks which are protected can be weighed up against each other. Fund managers also need to be able to convince trustees that their whole team understands the “structured products” invented by their derivatives experts.
The other practical obstacles were covered by a report in July 1993 from the Group of Thirty’s Global Derivatives Study Group. “Derivatives: Practices and Principles” suggests an excellent framework for how dealers and end-users should use and report on derivatives activity. The 20 recommendations it contains make a useful checklist for areas where trustees need to ask searching questions of their fund managers, for example:
What role do senior management play in the derivatives activity of your firm? How do they implement their policies?
How do you assess and manage the risks of your derivatives activities? How do you test your derivatives positions against possible changes in the market?
How do you assess and manage the risks of the opposite party in the derivatives contract defaulting on payments when the derivatives contract is valuable to me? What legal safeguards are in place?
What levels of authority do your personnel have for dealing in derivatives? How are these managed and monitored?
How will you account for and disclose derivatives activity in my portfolio reports?
As always, investors should keep asking questions until they understand the answers.
Things have moved on since July 1993. The Group of Thirty report also recommended that accounting practices on derivatives should be harmonised across the world. One recent step forward was the publication, in December 1998, of the International Accounting Standards Committee standard IAS 39 “Financial Instruments: Recognition and Measurement”. This specifically covers derivatives and hedging. It is intended to fill a gap while a group of ten other national standard-setters complete their discussions on how to apply “fair value” to derivatives contracts. The international group expect to issue a standard in the year 2000.
In the meantime, trustees can prepare themselves by making sure that they are completely familiar with how derivatives are currently used and reported in their portfolios. To start with, ask fund managers about currency hedging.
Far from being a four-letter word, derivatives are a useful investment tool. Those extra seven letters spell immense potential for risk reduction.
Sally Bridgeland is head of investment research at Bacon & Woodrow