Swiss pension funds embrace alternatives
In July 1996, the Swiss government introduced new regulations to govern the use of derivatives by Swiss pension funds. The move was prompted by the painful discovery in 1993 of enormous losses at the Landis & Gyr pension fund, which had been using derivatives for speculative purposes.
Under the regulations, pension funds may continue to invest in all forms of derivatives, as long as they are allowed to invest in the underlying assets as well. But all derivatives exposure must be fully covered by cash or the underlying assets. Furthermore, pension funds are forbidden from leveraging their entire assets. Finally, when calculating a fund’s underlying exposure, the worst-case scenario should always be taken into account and a special report should be prepared by the custodian bank or the pension fund accountant demonstrating the impact on the value of the assets should this occur.
In reality these regulations are not especially rigorous. They are meant to limit derivatives exposure and prevent unwarranted leverage being used, but are still very flexible and allow for the use of any kind of derivatives instrument. Furthermore, recent evidence suggests that pension funds are making greater use of this latitude.
According to a survey carried out in 1998 by Robeco and two Swiss publications, 75% of Swiss pension funds now use derivatives. Most of the respondents revealed that they were using them exclusively for hedging risks or gaining exposure to markets with limited downside potential.
In our experience, however, the situation is more complicated. In fact, over the past few years Swiss pension funds have been using derivatives for purposes other than those described above, particularly in the areas of currency hedging and return enhancement strategies. Furthermore, we believe that while major Swiss institutional asset managers tend to shy away from using derivatives, internally managed funds, on the contrary, make extensive use of them.
Institutional asset managers explain their aversion towards investing in derivatives on the grounds that it does not fit in with their overall investment philosophy, which is long term and involves being fully invested at all times. Market timing, they add, does not come into the equation.
So what types of derivatives strategies are being employed by Swiss pension funds? In our experience, the most commonly used are currency hedging, tactical asset allocation, risk limitation and return enhancement.
q Currency hedging Currency forwards are the most commonly used form of derivative, although currency is rarely managed as a separate asset class. In most cases, currency forwards are systematically used to hedge the currency risk on bond investments back into Swiss francs. There are probably two main reasons why currency hedging is so popular.
First, numerous studies have shown that for a Swiss franc-based bond investor, currency is a significant risk element that is not rewarded and should therefore be eliminated. Secondly, currency hedged bonds do not fall into the same legal investment category as normal foreign currency bonds and are therefore subject to less strict limitations.
In terms of who is doing what, many large pension funds are applying currency hedging on their internally managed funds, particularly on the bond side. Most asset management houses, however, are not using currency-hedging techniques unless a client specifically asks them to do so. Yet, having said that, some managers are offering Swiss franc hedged bonds as a packaged product.
q Tactical asset allocation Futures are recognised as the most efficient method of implementing tactical asset allocation (TAA), but a limited number of pension funds use them on a regular basis. In fact, for most funds adopting a segregated approach, the use of tactical overlay is practically non-existent. TAA simply consists of an internal investment committee responsible for allocating cash flows judgmentally or mechanically to different asset managers. Due to the fact that investment committee members are not usually investment professionals and meet infrequently, TAA tends to be oriented towards the medium term rather than the short term and its extent is therefore very limited.
In theory one would expect external asset managers managing balanced mandates to make extensive use of derivatives for TAA. In practice, however, this is rarely the case.
q Risk limitation strategies – options writing Although most pension funds claim to use derivatives exclusively for hedging risks or gaining exposure in markets with limited downside potential, in our experience their use of such strategies has been extremely limited. Asset managers have been similarly wary. However, it would be premature to draw any conclusions from these findings given that the financial and economic conditions that have prevailed over recent years have not been particularly favourable for such products.
q Return enhancement strategies – options selling Under favourable market conditions, some internally managed funds have been using these strategies, and a few of them have made extensive use of them over recent years. Among the asset managers, meanwhile, most of the major players are not using these strategies at all, although some may use them when permitted by the client.
There is a clear evidence of larger pension funds diversifying into alternative asset classes that seek absolute returns via derivatives strategies. This is significant because large pension funds often blaze a trail for the smaller funds. In future, Swiss pension funds’ use of derivatives may become much more extensive.
Gioacchino Puglia is a senior investment consultant with Watson Wyatt in Zurich