Not yet ready to go naked
On the face of it, there are few businesses that should be more enthusiastic about derivatives than the asset management industry. Corporate use of derivatives, typically to protect earnings, remains controversial: do shareholders really want to be ‘protected’ from volatile earnings drivers, or is the promise of higher risks and returns the reason that they invested in the first place?
By contrast, asset managers are typically acting on the basis of a much more transparent mandate and a much more clearly defined benchmark. In the case of active management, the expectation is that the managers will, by dint of superior knowledge, outperform the benchmark. That makes the use of derivatives seem almost natural. After all, if managers are getting paid to make well-informed bets, shouldn’t they exploit leveraged instruments like derivatives to maximise returns?
From this perspective, an ideal trade for a manager who has a clear idea about the ‘right’ price of a stock would be to sell put and call options on the stock at levels that reflect his or her ideas of when the stock becomes a good buy and when it’s time to sell. This strategy earns the manager premium when the market trends sideways, delivers the stock when the price is depressed, and enables an exit when the price is high. In short, it does nothing but add (in the form of the option premium) to the possible return on the underlying strategy.
The same could be said for many other derivative strategies, involving either more complex combinations of derivatives, or more ‘exotic’ instruments. Derivative fans are quick to point out that even if the instruments themselves are complex, the strategy they implement can be quite simple – and need not involve more risk than any other well-defined investment strategy. If a manager really is going to hold until the price is right, it doesn’t make too much difference if the instrument in question is the stock or a derivative on it.
That ethos drives the major purpose to which pension funds, and other institutional investors, put derivatives: asset allocation. Changing the portfolio mix through derivatives (usually listed futures) has a number of advantages over doing it in cash. First, using derivatives costs a lot less. Buying equities through the futures market can cost as little as a fifth of the cost of buying cash stocks, particularly when various tax breaks are taken into account.
What’s more, they’re less disruptive than other ways of changing asset allocations. Unless the fund really is changing direction for the long term, making a tactical move can be both difficult and disruptive. Telling the UK equity manager that his position is to be halved for tactical reasons may leave him frustrated and resentful – conditions that, some argue, are much more likely to cause risk management problems than investing in liquid and relatively simple listed equity futures.
And the beneficiary of the switch may also find themselve struggling to manage the suddenly increased portfolio – another situation which potentially increases the risk of underperformance. Buying in through the futures market, using a portion of cash reserves, can allow a more gradual transition.
But outside of the hedge fund community, asset allocation is about as far as pension funds’ derivatives use goes. Most uses of derivatives are relatively simple, and frequently defensive, with funds preferring to take on derivatives that look like familiar instruments and familiar risks.
Convertible bonds are one example. Funds, particularly in continental Europe, like these, says Win Robbins of Credit Suisse Asset Management, because they offer a way to get equity exposure – still a somewhat scary prospect for some European funds – without forsaking the familiar territory of blue-chip credit risk.
But why don’t funds just bite the bullet and start trading derivatives – in this case, equity options – ‘in the raw’? One reason, says Robbins, may be that they don’t like the fact that options can drop to zero value, and tend to be short-dated. Convertibles, by comparison, are longer-dated and remain tradeable under most normal circumstances.
But beyond that, most observers agree, funds and other institutional investors just haven’t warmed to the idea: using naked derivatives simply isn’t on the radar for most firms. Why not?
The simplest, and most basic, reason is the curse of the ‘D-word’. Ever since the rash of disasters in the mid-1990s derivatives have earned a bad reputation among pension fund trustees, who frequently don’t want to hear anything about them.
As numerous observers have noted, derivatives, and derivative strategies, are only as unpredictable or risky as the markets that underly them. “You don’t say: The equity market crashed in 1987, so stocks are obviously lethal and we’re never going to touch them again,” says one frustrated dealer. “But funds do say: a few people got badly burned on equity derivatives five years ago, so we’re never going to touch them again.”
But trustees’ caution is to some extent justified. It may not be fair to blame derivatives themselves for losses that were more directly caused by failures of control, or ill-judged and unwarranted speculation, but there is no doubt that the leverage they offer means they should be handled with care.
As other branches of the financial services industry have discovered in recent years, using derivatives securely is not so much about understanding the rocket science of pricing as it as about managing the operational risks of the people and systems which trade them.
Rogue trading on a large scale is clearly only an extreme case. But smaller irregularities in trading – whether deliberate or inadvertent – are another reason why derivatives haven’t taken off. Most managers simply aren’t as confident, or as disciplined, about their investment strategies as they need to be to use derivatives in the way suggested above – and most of them know it.
And while managers may talk up the rigour with which they develop investment policies and see trading strategies through, that’s less often the case in practice.
Derivative strategies go wrong when people try to sell out at unanticipated times – a classic example being that of Metallgesellschaft, the German manufacturing conglomerate that in 1993 lost $1.3bn (e1.5bn) by closing out a hedge position in energy futures. It is still debated as to whether the company did the right thing by pulling out and taking the loss, or if it would have been just fine had it stuck to its guns. One thing that both sides agree on is that the hasty and unprepared manner of its exit cost it dear.
Most asset managers, driven by the need to stay close to their benchmark, don’t have the courage to stick to their guns when the pressure is on. When relative, rather than absolute, value is the name of the game, no one wants to cash out for a few basis points in option premium while their peer group follows the market to the moon – or make a bad thing worse by buying into a falling market. That means that potentially valuable exercises, like buying option-based protection on a portfolio when markets seem overvalued, can fall by the wayside.
Doing so can actually make trustees more nervous, rather than less. Trustees think their managers are doing a good job if they stay a few points ahead of the market – whether down a few points less than the benchmark, or up a few points more. That means that even more staid strategies like buying put options to protect against downside risk, can arouse suspicion. If a manager’s losses are capped well below the decline in a benchmark, uneducated trustees are likely to suspect that something fishy is going on, or that upside potential will prove similarly capped, even if the manager is actually protecting value.
Clearly, a large part of the answer to this dilemma is to educate trustees in how derivatives change the risk profile of the business. While this may not win them over to using derivatives in the portfolio, it does at least help to ensure that they will not over-react when the returns behave in an unfamiliar way.
Making the asymmetric payoff profile from options more explicit in reporting is one way to do this. One simple way is to include projections of performance under a swing of plus or minus 20% in the benchmark – a very simple scenario analysis that illustrates the expected behaviour of the derivatives strategy. If the trustees accept the asymmetric payoff it makes it easier for managers to use derivatives in the disciplined manner that they merit.
Even then, the trustees need to be confident the reports they are getting are sound. “The problem is that everyone on the buy-side is used to getting their risk management for free,” says one risk management technology vendor, “or at least, to not paying for it explicitly.” That means that trustees rely on their managers to keep derivatives risks, where they exist, under control, and to report them back accurately.
Managers, in turn, rely heavily on broker and dealer estimates of prices, and particularly volatilities, when it comes to pricing derivatives – the kind of reliance that has got derivatives users into trouble in the past. The result is that many funds, and their managers, under-invest in risk management, relying instead on third-party assurances of security.
Trevor Robinson, an independent consultant on derivatives for institutional investors, claims that this, coupled with managers’ increasing dependence on automated reporting, means that an increasing number of reporting and pricing errors – some of them blindingly obvious – slip through the net. He believes that trustees need to pay more attention to what their managers are telling them.
Despite this, Robinson says he is certain that derivatives have a valuable role to play in fund management. The leverage they offer, he says, should be seen as no less acceptable than holding cash. “Holding 20% cash is the same thing as being 0.8 times leveraged,” he argues. “If pension fund trustees are confident in letting their fund manager reduce leverage in that way, should they not also be confident in permitting him to increase leverage by a similar amount?”
Morris Grantson is a freelance