This year, staff from the global offices of Wasserdicht pension funds are in Amsterdam for our annual get-together. This explains why I am hosting the event.
So at 08.33 on a damp Tuesday morning the first question to my colleagues is this: ‘If you had complete power to determine both asset allocation and execution, how would you use derivatives in your portfolio?’ You might think that our pension fund directors would relish dealing with this question but I saw confusion.
Helmut from Frankfurt and Pierre from Paris, reacted first. ‘C’est pas possible’, ‘Wahnsinn’, were a couple of their comments. ‘Why?’ I asked. ‘Because leverage is to blame for our predicament and did not one famous American say they are weapons of mass destruction?’ And with that the Franco-German alliance sat back, daring a counter-attack. Tokui San from Tokyo kept quiet, Cliff from Toronto looked at Jim from Dallas. Jim spoke.
‘Guys, I know you Europeans are pretty pissed at us, and that you are sure it is all our fault, but actually it is not, and I get totally bummed by all this crap floating around.’ No reaction. Jim continues: ‘Guys, we all have high return targets, so do we just continue piling into the same old equities and trust in a new bull market to happen, or do we think anew how we can build stable well diversified portfolios by using all the tools at our disposal?’ ‘By tools you mean derivatives?’ ‘Yes’.
‘Mais non!’ ‘Nein!’ Jim looked around the table. I tried to calm things: ‘Jim is saying there is a difference between using derivatives to diversify risk, rather than to concentrate risk.’ My European colleagues were not convinced. Cliff piped up: ‘Actually I know of a few plans that really were risk adverse, and they only had long-only investments in US government-backed securities.’ ‘And they were happy?’ asked Helmut. ‘Well no, they were in agency-backed mortgage bonds and there was leverage embedded in them. A lot of it in fact.’ ‘They were very unhappy,’ explained Jim helpfully.
‘If we look at our portfolios and our funding ratios, we are effectively being forced to find more return by concentrating risk in equities, and yet now we need to escape the trap. We need regulators to encourage sensible usage of derivatives to improve portfolio structures.’
‘Ok then, Pieter, what would you do?’ ‘Well, if I was allowed, I would use leverage to increase exposures in a low-risk portfolio, for example in government bonds. I would buy futures to increase duration. I would also invest in a lot of different hedge fund strategies. We know that uncorrelated returns from alternative risk premia helps expand the efficient frontier, so why not do it?’
Tokui San spoke up. ‘In Japan, if someone gets hurt with a hammer the regulators don’t ban hammers’. ‘So what happens?’ ‘They help teach us how to use the hammers correctly.’
Pieter Mullen is investment director at Wasserdicht Pension Funds