Comfort from derivatives
IPE asked three pension funds in three countries – Denmark, the Netherlands and Switzerland – the same question: ‘Do derivatives perform a useful function in pension fund portfolios or are too costly, complicated and risky?’ Here are their answers:
Hasser Jørgensen, chief investment officer at Denmark’s PFA Pension which provides corporate pension schemes to Danish companies and has AUM of DKK200bn (€27bn).
“We are primarily an in-house manager and we have a professional in-house investment organisation so derivatives are not too complicated for us to handle.
“Derivatives is a very broad range of different instruments, and OTC derivatives might be expensive but pooling them is not necessary with the asset size that we have.
“We use a broad range of interest rate-related derivatives, including CMS floors, receiver swaptions and swaps, and we also use quoted futures contracts in equities and bond markets for tactical asset allocation purposes.
“But the bulk of derivatives for us are for strategic hedging purposes, to hedge the mark to market valuation of insurance liabilities, which are created daily on the basis of, changes in the euro swap yield curve.
“They provide a very useful function within the strategic hedging range because what we need there is optionality or convexity, we need instruments that don’t have the same exposure to interest rates whether they are going up or down, we need instruments that give us protection on the downward loop.
“Direct costs in derivatives are not a big factor. The problems arise if you are into relatively illiquid instruments, then you will have to consider how you pay a price from the market spread and the impact that your own transaction has triggered.
“If the transaction is very large you will probably have to pay a liquidity premium when you do the trade in the market and you will also risk impacting the market given that certain market participants will expect further transactions and if you are going to do them it will probably be at a higher price.
“Risk is a factor and it can only be overcome by ensuring that the organisation handling derivatives is professional and competent with all the up-to-date controlling and reporting that is required.
“About 80% of our use of derivatives is to get of risk that we have on the balance sheet so in that sense you could say that they are not risky as long as you know what you are doing and precisely how you are positioning yourself.
“For other purposes, for tactical asset allocation purposes, derivatives are risky if they are out of control, if you don’t have the required operational set up. But apart from that, looking at market risk in general, they are no more risky than buying or selling in the spot market.”
Paul van Gent, fund manager at PME, the Dutch industry-wide Metalektro fund, which has AUM of €18bn.
“The perception that derivatives are expensive is largely a fallacy. Derivatives that are symmetric in nature, like swaps and futures, are usually quite cheap because in essence you are buying a simplified version of the underlying securities.
“Products that have non-symmetric return distributions, like options, where you usually have protection in the downside, have costs, but it depends on interest rates, volatility and the strike price at which you buy them.
“With options you can get into continually changing exposure, and that makes life a little more complex. But we use non-symmetric-type derivatives sparingly so we can deal with it – I don’t think it’s ever been more than one position at a time in an option.
“If you have a view, cost is relative and derivatives can be quite cheap while if you don’t have a view they can become costly because you end up paying for things you don’t need.
“And yes, they can be complex and the complexity starts with getting the agreement of a fund’s board to use derivatives, and the more asymmetric they are the more difficult it becomes. But our board has instituted an investment committee to tackle the more difficult issues.
“Then you have the complexity in the execution part and here the traditional custodian may not be ideal in recording a number of the factors that are important for a derivative. A custodian is used to tracking the value of an instrument whereas what’s important with a derivative is its notional exposure.
“For example, if you’re buying an equity futures for v100m it’s like owning v100m in equities and whether you make v3 of profit or v3 of loss, which the custodian records as the value of the position, is secondary. Yes, it’s good to know, but the management really wants to know how it is positioned in the market relative to its goal. We have designed our own information system to track this and to change data into information.
“Complexity moves almost seamlessly into risk and if you don’t manage the complexity you run the risk of not being where you want to be. That can be handled in-house or by hiring consultants to provide the information on a regular basis. That adds to the cost and for a smaller fund that could cause a problem but for a larger fund the cost of derivatives is low.
“A smaller fund might be able to reduce the complexity by limiting the actual number of different instruments being used by just making a list of the instruments it can use and not go outside that even though there might be interesting opportunities.
“There are other risks, for example that trades won’t be registered, because it’s not as if there’s a three-day settlement – if you go through an exchange collateral has to the posted, with OTC it becomes even more complex.
“But we reduce the risks by limiting the number of counterparties, by ensuring that different levels of the management are associated with different deals and that they report to the custodian, not only to the person doing the trades. We also have a double administration of trades and have more than one pair of eyes overlooking a trade before it’s executed and more than one person from our side present during the phone call when a transition is done.”
Jean-Pierre Steiner is chief executive officer of the Swiss Nestlé Fonds de Pension, which has approximately €4.3bn in AUM.
“Derivatives are extremely useful, and extremely important if you want to manage your assets in an efficient way. We have used them already for many years - modestly I must admit, except futures and options, which we have been using a lot in different portfolios - and also swaps and other structured products, including commodities.
“In the future we will make an even more extensive use of derivatives because we will be doing more and more alpha transport strategies, and you need derivatives to do that.
“The statement that derivatives have a reputation of being expensive is too broad. Some derivatives might be. Some structured products might have some hidden costs if you don’t look at them properly.
“But other derivatives - like futures - are really rather cheap. Trading costs are quite low and the spread on most is not too large. You can’t apply such a general statement to all derivatives.
“Derivatives aren’t that complex to explain to trustees. Swaps and futures are really straightforward instruments. Even options are. Some structured products can, of course, be very complex but the most basic derivatives are not complicated, and can be explained to trustees.
“But what I am wondering is whether trustees need to understand them? Yes, they need to understand the risks involved but not exactly how derivatives function.
“The exchange-traded derivatives have a much lower counterparty risk than anything else, because the counterparties are all broker-dealers that belong to the futures stock exchange. So you don’t have one counterparty but a number of counterparties who are all liable as a group, and not individually.
“Do pension funds require a certain level of sophistication to invest in derivatives? Pension funds either have a good professional internal team or they outsource the management of their portfolios. If they outsource to any professional investment bank, obviously those banks have the knowledge to do this.
“So it’s probably not the right approach to ask ‘should a pension fund know how to use them?’ because the pension fund itself does not perform the management function.
“The role of the consultant when it comes to investing in derivatives depends on the country. I think it is fair to say that the UK is lagging in using derivatives, certainly the US, and maybe some other European countries.
“This might be - I don’t know the facts - because the consultants have not been very dynamic or forward-looking regarding the search for new instruments like derivatives.”