Learning a language 3
FB Are you saying that that the search for alpha leads to derivatives?
TC Well I think the problem at the moment is that if you look at all the basic ways of structuring a portfolio it doesn’t add up to the return you require. It’s probably a little bit clearer that this is the case in Europe where there’s often a particular return requirement – in the UK we’ve perhaps not got that. We are looking for a little bit of extra return and looking to see where we might find it. The problem for a lot of pension funds is, of course, they’ve always been told that derivatives are a zero-sum game.
At the end of the day, given there are so many other experts in this field pension funds can feel like the naïve guy who has come in to be on the losing side to feed somebody else’s gain. One can certainly see ways in which money can be made but it’s got to be entered into very carefully.
AG We did some work on asset allocation decisions. If you look at the stock market rally, one of the problems it created was with rates of return. Because interest rates were low and not at the levels that funds required, it was very difficult for a fund manager, insurance company or pension fund to sit on the sidelines and look at the market that is increasing by 25–30% a year and not become involved in that market. As a risk manager what you’re looking for is a low correlation and a high rate of return.
The problem is everyone has the same amount of information together, they are all looking at the same asset problem at the same time and all start simultaneously making the same allocation decisions. A good example would be the flood of money out of equities and into bonds. As more people invest in the same product it creates a false sense of security because obviously the value of the product that you own goes up and that sucks in more money.
Often the only driver behind the increasing values is the fact that more investors are buying. Once that stops it becomes a game of chicken to see who gets out first. If you don’t have an offset then you are in serious trouble because underlying liquidity can quickly dry up. Investors end up with assets that are losing value rapidly and are forced to sell when nobody wants to buy.
Exchange-traded options may not be necessarily long-dated, although there are excellent reasons why that’s the case because of the concentration of liquidity in the short term. Nonetheless you can still replicate long-term structures. A form of offset is essential in these situations because otherwise you are going to be a forced seller. It’s far better being able to say, okay, I have bought an insurance policy that is going to cover me so that I can hold assets for the long term.
GS You raise a very interesting example because one of the strategies that one could have done in 1999 is to sell equities once you had made gains of 20 or 25% and then buy call options. Those options might have cost you 3% or so, so if the bull market went on then you would have still had more profit and when the market correction came or the markets stayed at this level you would have had around 22% return on the safe side. Firstly though, I don’t know anybody who actually did this. We had discussions with trustees, but eventually did not realise such a strategy.
It seems that people prefer to lose money the conventional way with long strategies, rather then spending some option premium to preserve performance. Some people somehow seem to have the feeling that if your house does not burn down then buying the insurance was not worthwhile. I agree with all the other people here that it has to do a lot with education and taking fears away from derivative strategies.
KR We’ve talked a couple of times about the analogy of options and insurance and I feel there is a misunderstanding. The fundamental basis for insuring our house is that none of us believe that the same event is going to make all of our houses burn down together so we think that maybe one person’s house will burn down and we’re prepared to share that risk between us. That’s fundamentally different from buying an option or selling an option where the same event is going to impact on every market participant in exactly the same way. If you don’t actually hold equities then clearly you’re not interested in insuring yourself against the risk that they go down. I think it’s important because the way I understand equity options is that what you’re really doing is making a bet on implied volatility. You are trading volatility when you buy an option because the implied volatility in the option price tells you how you could hedge that portfolio yourself. If someone is going to charge you 5% for a put option then what that is saying is that you could take 5% and manage it yourself by using futures and provide exactly the same protection, provided the actual volatility is equal to what was embedded in the price of that option. If 5% is the right amount to pay for put options it is simply a feature of whether the actual volatility in the future is above or below the level of volatility that is assumed in the pricing. So really when you think about trading options you are making a bet on whether future volatility is higher or lower than the volatility that the bank uses in producing the price.
That is why fundamentally I have an aversion to the use of these strategies by trustees. If you have some expertise in trading volatility then that’s fine, but most of the trustees that I know don’t have that sort of expertise. If you don’t have that expertise then you’re just as well off hedging it yourself dynamically, and if all you’re really doing is paying a bank to assume that role for you then I think it’s a different activity.
CL You’re right in that you can buy protection by buying an option or replicating that option yourself and you produce a similar pay off as to the pay off you get if you actually bought the option. I think the question pension schemes have to ask themselves is whether they are able to do that replication better than an investment bank? If markets start to fall a pension fund would have to sell equities, and, as they start to rise again, the fund would have to buy them back. I would strongly argue that investment banks are in the best position to do that sort of trading activity just because of the various options positions they have on the book. If I invested in equities as a pension scheme and I wanted to hedge out that risk, the best alternative would be to go out and buy the option rather than to try and hedge out that risk myself, because there are other players in the market that are much better at that sort of activity than I am.
GS In my opinion it always has been the investment banks and the market makers that really trade volatility. The end-user requires a certain profile or wishes to change their return profile in a certain way and with this he has to accept the volatility that he’s been paying with exchange traded products. But, we would not trade volatility.
KR I think what I’m talking about is looking at a persistent strategy of say holding equities and purchasing puts. I think if you then try and model that through all its ramifications what you land up with essentially is probably losing out against just having a more appropriate underlying asset structure that gives you the risk return profile that you can bear. If you are prepared to be very tactical about when you put options in place then maybe you can get a better result, but that sort of tactical expertise is then very much dependent, in my view, on whether the volatility pricing is correct or not. If it isn’t, then in the long run you are going to be probably worse off by having a persistent programme of options.
AG Volatility is freely defined by the market place. As a market marker when an end-user trades with us, we make money from the bid/offer spread but often we lose money from the core position.
GS I do not believe that derivatives should be implemented at all times. Derivatives are not for the long term. They are for certain risk/ return profiles that you wish to change at certain points in time or to insure against market movements for some time. But always being long stock and long put is certainly something that I do not feel is a good thing to do. It’s a waste of a premium.
RL It might be an interesting strategy though!
GS But not for a pension fund that maybe does not have all the trading capabilities, people and software and so forth like the banks have.
RL Possibly not. But I think in an area where you think the equity risk premium might be 6%, throwing away 3% per annum on good options may not be that stupid an idea in the sense that you’re not actually throwing it away. There’s a reasonable chance on a probability weighted basis that you’re going to get most of that 3% back in a form of return when the market falls. I think one of the difficulties for pension funds is trying to square the expected return for a strategy that uses options with conventional financial economics. There isn’t an easy analytical framework to place strategies that repeatedly insure.
VM What we are seeing is that these types of programmes where you buy or sell options may be less suitable for a pension scheme subject to frequent contributions and or withdrawals.
What we see is that we more often implement long-term strategies that are part of a programme that maybe runs for five, 10 or 20 years where there is no risk of your strategy suddenly becoming at odds with the market and where, for instance, you can’t buy put options because the volatility has spiked up.
CL Where options are particularly useful for a pension scheme or a life fund is to hedge specific risks that the scheme pays out. If you have issued capital guaranteed bonds then it makes sense to go out and invest in equities and buy put options with terms that match the same terms as the capital guaranteed bonds. So it’s specific asset/liability matching. Also it makes sense to hold options if you want to protect the solvency of the scheme at a particular level. An option structure might be the only type of structure that will ensure that you meet your solvency target.
Where buying put options is probably not appropriate is if you are trying to reduce the volatility of the returns of your fund. You’d probably get a much better outcome if you just reduced your equity exposure. But where you are matching specific liabilities or targeting a particular solvency level in a fund is where options strategies can make sense.
KR I said earlier on that I thought we were about to see an explosion in the use of derivatives and I think that the main area, certainly in the UK context, is in fixed income mandates and particularly in the swaps market. We have an environment where UK pension funds have historically had very low bond weightings. They are now in the process of increasing those bond portfolios and thinking much more carefully about how to get the bond portfolio much more closely linked to the liabilities, which means having a very long duration. It also means having a fairly high proportion of inflation linked type debt and some of the inflation linkage we have in the UK has got caps and collars so it doesn’t go above 5% and doesn’t fall below zero. That lends itself very easily and neatly to swap type strategies.
So I think we’re going to see an enormous explosion now because the whole bond market is very much driven off the swaps market and swaps and bonds are almost perfect substitutes for each other. I can’t see any reason why we would find resistance to that. From a performance enhancement point of view if you want a bond manager to try and add value there’s very little reason in my view why you should restrict that manager to the sterling bond market. At the end of the day a UK pension plan or European pension plan might want a return in their local currency and with the right sort of duration then there should be no reason why they shouldn’t hold US or European bonds or any other bond and just swap the currency exposure back into the domestic exposure and adjust the interest rate exposure separately. If you want a long-dated return but you find the best value in short-dated US bonds, there’s no reason why the active manager couldn’t buy short-dated US bonds, swap the currency back and just lengthen the duration using swaps and get you back, if you like, to the overall risk profile that’s appropriate, but whilst trying to take the most valuable situations.
We’re doing a number of these mandates at the moment where for a bond portfolio the objective is really to outperform some long-dated sterling benchmark but invest in bonds anywhere in the world and to try to transfer that value back into sterling using swaps. I think this is going to be the standard way that bond mandates are run over the next few years. That’s an enormous use of derivatives and provided you put the right controls in place you can avoid gearing or you can avoid taking uncovered risks.
TC Can I just ask where you think the expertise is going to come from, because obviously bond expertise in one manager may not necessarily mean they have the swap expertise. Are you putting these two things together?
KR I think at the moment you do still have some houses that can do the bonds but can’t do the swaps but I don’t think they’re going to be survivors. If you’ve got the expertise to evaluate bonds then you’ve got the expertise to evaluate swaps and all you need is a computer system in place to deal with that. I don’t think those organisations are going to survive that can’t do swaps.
VM One thing we haven’t touched on is the fact that regulators are pushing institutions to move towards more derivative based strategies. In the UK FRS17 is the way that will drive many institutions to use derivatives just to reduce the volatility of the value of the pension fund in the financial statements of the sponsor. This is one area where clearly the regulator knows that more derivatives are going to be used.
In the UK we’ve seen CP135 and CP185 and the relaxation of traditional efficient portfolio management rules and I think we haven’t really heard the FSA at any point in time say that they were concerned with the use of derivatives. In fact they’re actually pushing for them by the backdoor. We’ve also seen in Spain, where we have worked for the externalisation of some pension fund liabilities and worked closely with the regulators in implementing these solutions, that they have approved derivatives.
Also the Inland Revenue in the UK is working on the taxation of these instruments and they’re going to be favouring the use of the more simple swap instruments. All of this is going exactly in the same direction, as Kerrin was mentioning before. Another factor we haven’t talked about, which is maybe more mundane, is that a lot of people, including actuaries, are actually being trained now in derivatives and obviously that’s going to change the landscape significantly.