Learning a language 1
FB I’d like everyone to give a little bit of background as to where they are in relation to using derivatives. We want you to describe how you use derivatives and why you think institutional investors should be interested in using them?
VM Axa was one of the first insurance companies in France to actually start using derivatives for the management of their assets and liabilities – almost 10 years ago now – so we have the experience and practice of using them to solve issues that I think many pension schemes are being faced with. So, I would say that AXA uses derivatives quite intensively now. We are also now advising some of our external clients in the use of derivatives. Derivatives don’t generate return by themselves. We see them as very useful in a sense that they help reshape the risk/ return profile of whatever asset class an investor is investing in.
MR What has happened over the past three years in the equity markets has raised the issue of how to measure performance in a portfolio in general – ie, is it relative or absolute performance? The next question is how to protect the portfolio against unforeseen incidents, such as sharp drops in the markets or what one could do in the kind of environment we have seen over the past six to 12 months where the market has been driven sideways? How can I as a portfolio manager create a return in addition to what the benchmark would provide or how could I use derivatives to protect the portfolio especially where there’s a lot of uncertainty with regards to the future market direction? The past 36–40 months have given rise to these questions and from our experience at Eurex there is a tremendous amount of demand in terms of education within the end user community.
What can be done to provide a platform for all participants such as the members directly connected to the exchange as well as pension funds, asset managers, hedge funds, etc? Furthermore, where are the benefits, advantages or differences between over-the-counter (OTC) and exchange-traded derivatives? Past experience tells me that there will be enormous growth in derivatives.
KR As an investment consultant we advise mainly pension funds on their investment strategies and also get involved in helping them decide whether derivatives are appropriate to implement those strategies. I think that in the past 10 years I have spent maybe five or six years of my working career trying to educate trustees about futures and options, but it was rare that any pension fund ever used them. Before, the energy came from fund managers who were asking for permission to use derivatives. Now we are in a position where I think there is a tremendous use for derivatives.
In fact I think we are on the brink of massive use of derivatives by pension funds.
MP I work for the investment management arm of Prudential and we use derivatives for a variety of purposes. We use listed futures for implementing tactical asset allocation decisions. We also use swaps within our annuities business for matching the assets to the liabilities and we use derivatives in structured product development.
AG We are a market maker. This means in essence that when a number of transactions go through the marketplace they end up on our books, in that the residual risk ends up with us. Our business is to anaesthetise that risk, principally via options, and to manage and control it so that we can continue to provide liquidity to the marketplace. We’ve branched out in the past three years and instead of being reactive to the marketplace and waiting for business to come to us – normally through banks and brokers – we’ve started going out and speaking to insurance companies and pension funds to try and understand their business and then explain our business to them. We build direct relationships, which is rather unusual, because what you don’t find in the financial markets, with the exception of FX, is direct counterparty trading . Normally parties are kept apart by middle-men.
RL SSGA has always been quite big in derivatives, but I think that in common with most asset managers this is through what is known in the trade as ‘delta one’ products, otherwise called symmetric products. I think that pension plans in the UK and Europe have a very strong need for these, so I agree with what Kerrin said that in the future in terms of transformation of exposures there will be very significant need for derivatives by pension funds. However, with asymmetric products I am a little more sceptical. I think they are sold and not bought, and often to the wrong people without a proper understanding.
FB Could you just explain the difference a little bit between so-called symmetrical and asymmetrical products?
RL A ‘delta one’ product would, for example, be a future where you gain exposure to an equity market, for example and you have all the downside exposure as well as all the upside exposure. An asymmetric product would be like an option where you’re protected against downside loss and you hope to participate in the upside as a result of your underlying exposure.
KM As you are aware, JP Morgan is a bulge player in most of the major derivative markets, both on the listed and the OTC sides, and across asset classes, including fixed-income, equity, FX and credit derivatives, to mention a few.
More important perhaps than our size is our advisory approach in the derivatives market, which really goes back a long way. Some of you may remember that, in the early 1990s, JP Morgan released its RiskMetrics in-house software, which we used to manage our own derivatives risk. We released it on the web to anyone who wanted it, which was considered a bold move at the time because some thought we were giving away a lot of our competitive advantage in the market. More importantly, it was felt that this would give more stability to the derivative markets through greater openness and understanding of risk management, which would ultimately lead to greater stability. In terms of the advisory side of our research, which supports both our market making and brokerage activities, we’ve recently merged our listed and OTC derivatives strategy groups with the view that investors care primarily about hearing one unified story, which addresses the inherent interest rate risks in their portfolios and how to manage it.
GS APK started using derivatives ourselves about two or three years ago. In the FX markets we wished to hedge dollar risk on our US equity exposure. This proved to be an interesting experience because it made the company comfortable with derivatives. Last year – and I think this is something of a success story – we added about a full percentage point of performance to our overall portfolio through this currency hedging strategy. Today we are on the status of ‘stand-by’ for managing equity market risk. Interest rate risk management is implemented by our external fixed income fund managers in very close cooperation with us, and by ourselves through bond ETFs.
What I think is essential when speaking about derivatives with pension funds and trustees are the names that are used. If we say that we want to hedge the currency risk then there is no problem with getting the okay from the board or the trustees for this. If we say that we are looking at introducing equity derivatives on the plan level then it would be much more complicated!
Another critical issue with derivatives is the decision-making process, especially the discussion and decisions about how really to change the risk and return profile of the plan.
Furthermore, the ultimate problem is not taking the decisions, it is making explicit what the expectations are – meaning getting decision-makers to say what their expectations are.
Why do we use derivatives or why do I feel that derivatives are important for pension funds?
The answer for us is because of the balance sheet. We have learnt the hard lesson that despite the fact that we are operating a long-term horizon, we have to make the end-of-year balance sheet and if the market volatility materialises in losses at the end of the year then you have a problem whatever your time horizon might be.
FB APK is one of the biggest funds in Austria, although the actual assets under management are relatively small. It’s interesting that you can use derivatives with that amount of assets.
GS We are now, thanks to the equity market, up to e1.6bn and exchange-traded derivatives fit any portfolio size. But what I should say here is that I worked for the Austrian derivatives exchange some years ago, so there is derivatives experience in our company. For the time being we use futures or forwards as they are simpler to understand. With the use of options you are managing volatility and it gets more complicated. At APK we therefore differentiate between futures-based and options-based strategies.
CL At Henderson I work with a team that focuses purely on derivatives and structured products. On the execution side we have certainly seen an increase in the use of derivatives in the UK. More recently we’ve seen quite a significant rise in the use of derivatives for reducing investment risk with a lot of companies and pension funds looking at various protection strategies to reduce solvency risk.
Another aspect we are involved in is advising clients. We’re finding that a lot of pension funds are coming to us asking for advice in relation to the use of derivatives and structured products. I have to say I think life companies have been more advanced in terms of their use of derivatives than pension schemes. We are also involved in structured products, mostly on the retail side but also on the institutional side. A structured product basically embeds some sort of bond and a derivative with a certain type of pay-off profile and we are seeing an increase in the use of structured products in the market. Internally we also manage derivative funds and more and more clients are interested in investing purely in derivative based funds.
JA I work for Aerion Fund Management, which is owned by the trustees of Lattice Group. Historically we were the in-house fund manager of British Gas. We use derivatives in two ways: firstly for tactical asset allocation by using futures to put in place any desired changes to our asset allocation quickly and cheaply. This is particularly important as our benchmark rebalances at the end of each quarter. Secondly, we use derivatives through the swaps market to move between fixed interest gilts and AAA credits and to alter the duration of our fixed interest portfolio. The fund is very mature and therefore has a high fixed interest exposure. Since the value of the fund is about £11bn we need to use the swaps market as a liquid and efficient way of altering our positions within our fixed interest portfolio.
FB One of the first things that happens when you mention the word ‘derivatives’ to a lot of pension funds is that they say they are too risky and refer to the notorious cases such as Long-Term Capital Management, Barings and Allied Irish. What are your thoughts on these attitudes and do you still find them prevalent?
What are the risks involved in using derivatives and how can they be mitigated?
VM I have this same impression. Very often the trustees or companies we speak to are wary of derivatives. I would say that generally to make losses on derivatives would not be considered acceptable by a pension fund, whereas it might be considered perfectly understandable to make these same losses on equities or bonds.
But if you look at the actual cases that you’ve quoted, they were actually mostly examples of a lack of internal control. In terms of risk mitigation, the first check is that anything that looks too good to be true probably is. I think what we are about though is to explain first of all that so many people use derivatives.
I wonder how many people actually know that 90% of the top 500 companies use derivatives to manage and hedge their risks, according to a recent survey by ISDA.
To make an analogy, what we explain to investors is that at the moment they are driving a Model T Ford. However, we are not proposing that they start to drive a Ferrari. What we are saying is that they should at least be driving a Mondeo, which is what everybody else is travelling in. Both the Bank of England and the French government are using these instruments extensively, so there must be a good reason for it! The main point is education and making people such as trustees feel comfortable with how derivatives work. They have to understand the strategy.
MR I agree completely. It comes down to education. But it’s not just about derivatives and how they work or what kind of risks they embody, it’s also about understanding what the risks are to the overall portfolio. Step number one is to know your own risk profile and how that can be managed. Then you take a closer look at derivative strategies and their individual risk profiles to find the perfect match. Quite often I’m under the impression that people think they know how to use derivatives and that it is going to help them deal with a potential problem. Then the market moves and you realise that it didn’t do the trick. There’s a mismatch between the risk that is being hedged and the instrument that is being used to hedge that risk.
Another issue is the potential lack of internal control and widespread understanding by those who are supposed to control the risk for the overall portfolio – the underlying portfolio plus the derivatives.
TC What exactly are derivatives? In funds, mostly a way of hedging! Should pension funds be interested in them? Well, of course they should, but the difficulty with pension funds, of course, is that their structure mitigates against their use in that you’ve got a lot of pension funds who hire specialist managers and give them investment remits. On top of that pension funds generally work a long time behind events.
On the whole it is very difficult to convince pension funds that the insurance argument for derivatives works. Pension funds don’t understand why they should pay a premium to insure their portfolio.
In normal life you don’t feel its money that’s been wasted if you’ve paid insurance and your building hasn’t burnt down. The argument isn’t quite there though when it comes to using derivatives to insure portfolios. With investment it is almost as though funds are wishing for the market to go down to prove that they were right to buy derivatives to protect their fund. If you get to the end of the year and your call was wrong and the markets have gone up then an insurance exposure seems to have been money wasted. Somehow or other the pension market needs to at least be educated in this use of derivatives, but I’m not quite sure who’s going to provide that education?
I think the other problem is that the structure of pension funds has moved away to a large extent from a bundled to a specialist structure. And then of course the question is who is going to do the protection. We had a spell 10 years ago, where tactical asset allocation seemed to be in favour. However, few people seemed to be able to make it work satisfactorily, and there is still the question of who exactly is really providing the necessary protection.
I suppose we will have to wait and see what happens with asset managers who are coming up with ideas that seem to be getting through to a number of pension funds. I think though that the past few years have been probably the best form of education that one could have that downward protection may be necessary.