UK - The use of derivatives in a pension fund portfolio could afford protection from equity risk - despite what Warren Buffett says, according to the former head of Fidelity’s pensions arm.
Speaking at the National Association of Pension Funds conference in Edinburgh yesterday, Trevor Robinson, the former director of Fidelity Pensions Management, said that derivatives should at least be considered as a tool in asset allocation, emphasising the need for education among trustees.
Holding up the equity market as a yardstick, Robinson explained that put options can protect funds from losses when equity markets are falling. Equity markets, certainly throughout the 1990s, were associated with rewards rather than risks.
The last three years have turned this theory on its head, and, said Robinson, “although equity managers try to beat the index regardless of whether the market is falling or rising, what they are more likely to do is outperform in a rising market, and underperform when the market is down”.
The boundaries of risk and reward have been challenged, he says, and now positive returns, rather than above-benchmark returns are viewed as reward. As pension funds look for alternatives to save themselves from equities’ risk - and are prepared to accept a new definition of reward - the use of derivatives should at least be considered.
Used sensibly, put options can provide less risk than equities, Robinson said. But the fact the trustees do not fully understand derivatives means that they are often overlooked.
And comments from renowned US investor Warren Buffett, who has described derivatives as “financial weapons of mass destruction” have not helped matters. But industry participants are trying to make equity derivatives more comprehensive to trustees, Robinson said.
Robinson added that it is not essential to understand the jargon, nor to understand exactly how derivatives work. Rather, it is important to understand the principles behind them.
“Trustees don’t need to worry about the details of derivatives, but like equities and bonds need to know principles of what they can be used for and should have a set of rules for the external fund manager.” A guidebook for trustees by the NAPF entitled ‘Equity derivatives made simple’ has been produced for just this purpose.
Robinson’s advice for trustees new to derivatives is to speak to their peers who are familiar with derivatives, look at the rules they have in place for their fund managers and then “dip a toe in the water” by investing minimally and watching the progress slowly.
Robinson now runs his own firm, Trevor Robinson Investment Management.
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