There is increasing awareness among pension fund trustees that derivatives can benefit portfolio management – and some pressure from fund managers to permit the use of more types of derivative products in their portfolios. However, trustees should exercise some caution. Not all managers have the operational capability to support increasingly complex derivative strategies. Trustees need to ask their managers a series of questions before they feel confident they are sufficiently protected from investment and operational risk.

Where are pension funds using
The use of derivatives in investment management is growing and so too is the understanding of the difference between using them for performance and protection. However, pension fund trustees have, historically, been nervous of the ‘d’ word. This trend is changing.

Most pension funds generally allow the use of derivatives for:
q Efficient portfolio management (EPM): Investment managers estimate future cash flows from pension fund contributions and use equity and bond index futures as a quick and cheap way to ensure these flows have rapid exposure to the market. Buying the underlying stock can be time consuming, more expensive, less liquid and there may be adverse market movements in the interim;
q Asset allocation (another form of EPM): Derivatives are often used in pension funds to shift the asset allocation of a portfolio. In tactical shifts, contracts can then be allowed to expire and the portfolio moves back to its original position. In strategic shifts, the fund manager can put the underlying changes in place over a period of time;
q Currency hedging: Many pension funds want to diversify investments across international markets but don’t want to take currency risk – forward currency contracts can hedge out currency fluctuations.
Pension funds also allow the use of derivatives in some investment strategies, such as fixed income. To access individual performance factors, such as duration or shifts in credit ratings (without the complexities other bond characteristics bring), managers are allowed to use some types of derivatives, such as swaps.

It is a changing world
There is pressure to increase the range and complexity of derivatives. But this is coming from individual fund managers themselves; not pension fund trustees. While there is no single clear model emerging of the rate of take up of derivatives in investment management firms, the table below shows a standard evolution:
Investment managers seemed to move slowly from level zero to level two, but then the transition to level three accelerated very quickly. Managers are looking for new and more exciting ways to add value. While this is a noble intention, pension fund trustees need to clearly understand the risks associated with these instruments. Derivatives require strong administration support. And the rate of derivative take up in investment management companies is not always matched by the growth in the business processes that support them.
Our research into the use of derivatives in investment management companies has allowed us to suggest a list of questions trustees should ask their managers, before approving wider use of derivatives in their funds.

Pricing and valuation
Pricing derivatives can be difficult. Open positions in exchange traded futures and options are readily valued by simple reference to the relevant exchange published closing price for that particular contract – it is standard accounting practice to use these prices. But what about over the counter (OTC) contracts? These cannot be freely traded by reference to a known real-time market price. In practice, managers refer to several sources of information to determine the value of open OTC positions.

Relevant questions:
How are you pricing OTC derivatives?
Where are the information sources for pricing OTCs?
Do these information sources allow daily pricing?

Trustees need fund managers to have transparent processes; they want to see what is traded and why. Using derivatives normally requires different order management and trading procedures to those used for physical securities. And pre- and post-trade compliance is indistinct – 18% of departments in investment management companies spoken to said they had very limited derivatives checking, and 70% said they had no derivative-specific rules.

Relevant questions:
Where is the source of market prices for valuation?
Who authorises derivative trades?
Is there an end of day trade confirmation?
Are trade details provided to the back office?
Does the fund manager’s trade processing systems have the ability to properly record both futures and options?
How are the trade details captured?
If a manager purchases a derivative on behalf of your fund, they will need to put up some collateral, either as a margin or as a deposit against default. Trustees should be aware that the manager does not pay this – it comes from their portfolio’s assets. By physically transferring the collateral into the name of the clearing member, clearing house or counterparty, the trustee loses ‘legal ownership’ of the collateral but retains the beneficial ownership - ie, the rights to any entitlements such as dividends. The client/manager loses the voting rights. Trustees need to be confident their managers have robust processes to calculate and look after the assets deposited as security for the contract.

Relevant questions:
What are the accounting entries for option premiums and futures variation and initial margins?
How are the initial margin and daily variation margin calls to be funded?
If collateral is used to meet initial margin requirements, what are the procedures and what are the costs incurred?
How is collateral reported?
Does the manager have the authority to use segregated fund assets as collateral?
Are there procedures to monitor the cost/benefit of funds using collateral to cover initial margin requirements?
Does our custodian understand these products?

The regulatory environment surrounding derivative use is changing rapidly. Pension fund trustees should make sure their managers are operating within legal and regulatory constraints, especially when the derivatives strategy is complex.

Relevant questions:
Is the compliance officer aware of the full regulatory impact of using derivatives?
Is there a regulatory environment group to maintain awareness about regulatory change?
Is the manager a member of any industry groups, such as the Futures and Options Association?

Performance measurement
A manager’s performance team needs to work closely with the back office to understand how derivatives information is being stored and how to reconstruct it for performance analysis purposes. Again, trustees need transparent performance reporting.
However, 60% of performance teams are not involved in the approval process for agreeing new derivative usage. If performance teams do not contribute to the establishment of back office procedures, it is unlikely they will be able to derive the performance returns and explain the investment rationale for using these new instruments. This lack of participation presents serious issues, especially when performance returns and attribution analysis feed straight into trustee reporting.

What about more exotic derivatives?
Many managers now want to use OTC contracts. Why? OTCs can be tailored to implement a strategy, without the need to buy several exchange traded derivatives. However, there’s no exchange to regulate price – it is all agreed with the counterparty. Trustees should be aware this can make risk control complex.
While potential additional staff and system cost overheads are the immediate concern for investment management companies, external transaction costs are important to trustees. On-exchange transaction costs are transparent. However, OTC transaction costs are opaque. Trustees and regulators expect transparent reporting from fund managers and, using the current operational support systems and processes, OTCs are proving difficult to administer.
There are also high volumes of unconfirmed OTC trades, ie, the details of the trade have not been properly agreed. And confirmation only comes from the counterparty – they can be unresponsive.
Fund managers could give up the value of bespoke tools for the absence of operational risk and hidden pricing costs – simply so that they have investments which are cleaner to use and to explain. Almost all OTC strategies can be replicated using exchange traded contracts.

Relevant questions:
What manual checks are in place to ensure risk control?
What if the counterparty defaults?
How are these trades confirmed?
Does the manager’s back office reconcile OTC trade details immediately with those logged by the front office?
Are there procedures in place for escalating the priority of any discrepancy?

Requests for approval to use derivatives are generally driven by the individual fund managers or new product developers. In considering approval, the crucial questions faced by trustees should be:

Relevant questions:
What are the benefits of using these derivatives?
Can this be proven through performance measurement?
What is the downside of using these derivatives?
Is the realisation of the benefit dependent on internal factors such as operational capability?

While the characteristics and risks associated with the most commonly traded exchange traded futures and options contracts are now well understood by many market participants, there are still some functions in investment management companies which could be improved. And when derivatives become more exotic, managers need to demonstrate an even higher level of due diligence. There’s no doubt that derivatives are beneficial, but trustees need to address the questions raised in this article before they can be confident their manager is using them wisely.
Ashley Payn is a consultant with Investit in London