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Special Report

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Light use of instruments

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Annual returns by Dutch pension funds to the Insurance Supervisory Board provide only very limited information, if any, on the use of financial derivatives.

For this reason the board carried out a survey in autumn 1996 on the funds’ use of derivatives. The survey included all pension funds, with the exception of the fully reinsured funds.

Of the 653 pension funds included in the survey, 169 use derivatives; 484 pension funds do not allow derivatives to be used. From a supervisory point of view it is worrying that a substantial majority of the funds who say they do not allow derivatives, 337, have not explicitly excluded their use.

Pension funds that do allow the use of derivatives can be subdivided according to size of assets. The use of derivatives is fairly rare among smaller pension funds. At the other end of the spectrum, nearly all funds with assets of at least Dfl1bn ($496m) allow the use of derivatives. Another distinction can be made according to internal and external management. Of the 169 funds that allow derivatives, 36 allow this for internal management only, 105 to external investment managers only, and 28 for both internal and external management.

The types of derivatives allowed for internal use quite strongly depend on the fund’s asset size. For the smaller funds the emphasis is on exchange-traded derivatives, in particular share options. The use of currency derivatives is excluded by virtually all smaller funds. This is not surprising, given that they hold hardly any direct foreign investments. For the largest funds the situation is very different. Equity index products and currency derivatives are allowed by most funds. OTC derivatives, such as currency forwards, are also quite common. This of course reflects the different investment policies followed by the larger funds, with an emphasis on tactical asset allocation, country allocation, and strategic and tactical currency management. Also here, share options are commonly allowed to assist an active selection of individual shares. The larger funds also quite often allow the use of fixed income derivatives. Overall, for equity and fixed income instruments the exchange-traded derivatives dominate. For currency products exchange-traded and OTC derivatives are allowed to roughly the same extent.

Where external asset managers are allowed to use derivatives, fund size hardly influences the types of derivative allowed, either in terms of type of underlying asset or whether the instrument is exchange-traded or OTC. This would appear obvious: one would expect any professional external asset manager to be able to make proper use of a wider range of derivative instruments.

As regards internal use, a clear majority of the funds which allow derivatives appear to use them fairly sparingly, or not at all. Over half carry out less than 25 transactions a year. More intensive use is largely confined tothe larger funds, especially those with total assets in excess of Dfl1bn. The sm aller funds that did have derivatives positions on 30 June 1996 used virtually exclusively exchange-traded equity options, mainly on individual shares, and some index options. No currency derivatives are used by these smaller funds; very often they do not hold any direct foreign investments. Larger funds use a much wider range of instruments, both exchange-traded and OTC. Their main currency derivative is currency forwards. The total actual exposure for the in-house managed assets, indicated by the nominal underlying value as a percentage of assets, is also relatively limited in most cases. Over half of the funds have less than 5% exposure, as defined above.

The actual use of derivatives by external asset managers is much less dependent on the size of the pension funds. Interestingly, the sort of instruments used resemble those used internally by the large pension funds: more index instruments and more OTC currency products, in particular forwards. Here also, the exposure as defined generally is fairly limited or there is none at all.

The actual use simply reflects thc sort of overall investment policy followed. The smaller pension funds using derivatives seem to aim for outperformance by stock selection. The larger funds and thc external managers also concentrate on tactical asset allocation, country allocation and a strategic and tactical currency policy.

There are exceptions to this overall picture. A small number of pension funds make active use of derivatives, with a substantial number of transactions or a high market exposure.

A majority of the funds that allow derivatives to be used have formulated written guidelines for their use. However, quite a sizeable minority have not. Most of the smaller funds, but also some very large pension funds which use derivatives internally have no guidelines. Similarly, over one in four of the funds which allow derivatives to be used by external asset managers have issued no guidelines.

When considering in more detail which limits have been set - by instrument, transaction, counterparty or total exposure - often no, or not every kind, of limits have been decided on. In particular where derivatives may be used by external managers, no limits appear to be included in the mandates. A broadly similar picture applies to the selection of exchanges or of OTC counterparties. Often, no approved lists exist.

In the survey, five main implementation and control tasks are distinguished - approval of transactions, execution of transactions, administration, reporting and control. For each of these, clear procedures are required. The survey shows a dichotomy between funds which have established procedures for all five areas, and funds which have no agreed procedures at all. Again, the answers show a certain size effect: larger funds tend to have established procedures.

Performance measurement and analysis is a useful tool in the control process. The majority of pension funds make use of performance measurement services, usually by an independent external bureau or consultant. The larger funds often use these external services in addition to in-house measurement and analysis.

The most active use of financial derivatives is mainly confined to a limited number of mainly large funds. These in general have established guidelines and procedures for the use of derivatives. The survey was not intended to assess the precise quality of such procedures, but only their existence. A further group of pension funds, large and smaller, is much less active in using derivatives, but has paid attention to the organisational infrastructure. A third group, primarily consisting of smaller funds, makes fairly limited use of derivatives but has not (yet) achieved the required quality of organisation. Apart from these three main groups a few funds show an active use of derivatives, without the required organisational standards.

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