Back in 1993, the National Association of Pension Funds (NAPF) asked member schemes if their investment managers used derivatives. Some 5% of schemes used options only, 10% used futures only, 28% used both but 57% used neither. This breakdown has not essentially changed, as the table shows. Derivative penetration has made little progress among UK pension funds and, if anything, may recently have slipped back a little.
Where a pension scheme’s investment manager does use derivatives, 68% of private schemes and 90% of public schemes place explicit limits on their use. These limits frequently take the form of a maximum percentage of fund value or a restriction to use for currency or other hedging purposes. In a small number of cases trustees must give specific approval for each occasion when derivatives are to be used.
John Rogers, secretary to the NAPF’s investment committee, commented that pension fund derivatives really only took off in the UK in 1990, when that year’s Finance Act exempted from taxation pension fund income from trading futures and options. That decision was taken exclusively to stimulate the London derivatives market. It is somewhat ironic that, at a time when UK pension funds are being charged to tax on their income from sub-underwriting and share buy-backs – because these activities are seen as examples of ‘trading’ rather than ‘investment’ – income from derivatives that clearly results from a trading activity is specifically exempt.
One example of a UK pension fund that uses derivatives is the Lucas Pension Scheme. Its lead investment manager is LucasVarity Fund Management (LVFM) which is responsible for the management of all the scheme’s assets except the emerging markets portfolio. The scheme’s statement of investment principles sets out the trustee’s policy on risk and explains that, to control risk, the trustee has imposed constraints on the use of derivatives so that they may not be used to gear up the portfolio for speculative purposes.
David Brief, managing director at LVFM, explains that the scheme’s assets are benchmarked within tactical asset allocation limits. For example, developed market equities (excluding UK equities) are benchmarked at 20% but can range within 15–30% of the portfolio. The majority of the assets are indexed and the LVFM aims to keep any tracking error as small as possible.
“We therefore make use of futures overlays to effect asset shifts,” says Brief. “We can only use exchange-quoted derivatives, as OTC products are expensive, pose a credit risk and are difficult to price. Although we are allowed to use traded options, in practice we avoid them because they are too time-consuming to monitor for a small team.”
A good example of the use of futures for asset allocation shifts is given in the Lucas Pension Scheme’s annual report and accounts. At the year-end March 31 1998, the scheme’s actual asset allocation to developed market equities (excluding UK equities) stood exactly on the benchmark at 20% by market value and after futures at 16%.
At the NAPF, Rogers thinks that trustees’ fear of derivatives is decreasing as they become more familiar with them. This is especially the case where schemes use specific benchmarks for asset allocation purposes. “If you want to adjust the scheme’s exposure to an asset class, it can be very expensive in terms of your investment performance unless you do it very efficiently and this means using derivatives,” explains Rogers. “Trustees can see in this situation that their investment managers use derivatives to reduce risk rather than increase risk.”
Brief stresses the relationship between the investment manager and the trustees. He explains: “We made a great effort in helping the trustees to understand futures and it may well be easier for a ‘home team’ to take the trustees down this route than for external fund managers.”
The promotion of the proper use of derivatives by UK pension funds continues. The NAPF investment committee invited Neil Rudolph, chief operating officer of San Francisco-based Symphony Asset Management to address its 1999 spring conference in Eastbourne. Rudolph’s talk, “Hedge funds: worth the risk?”, was well delivered and informative. He began by defining hedge funds as “investment vehicles or strategies in which both long and short investing is allowed and in which leverage or gearing may be applied”. Perhaps it was my imagination, but I thought I sensed a slight stiffening among the conference delegates as they listened to those words.