Derivatives cut both ways … even in experienced hands

There is still a degree of bad taste in the mouths of trustees when it comes to the use of derivatives in pension fund management, but some funds that have embraced the investment tools, such as HOOPP in Canada, are now reaping the benefits.

And those benefits are widespread, according to Jim Keohane, chief investment officer of HOOPP, reflected in both risk management and performance, as they allow more precision in the risks that are taken. Plus, pension funds can use derivatives strategies to create an investment exposure that would not be possible with physical securities.

Derivatives are a sophisticated and complex tool which, in the wrong or inexperienced hands, have the potential to do some serious damage. But in the right hands the benefits are numerous.

HOOPP has been using derivatives for more than 10 years, first indulging as part of a strategy to get around a foreign content rule. It quickly realised there were a lot of uses for the instruments and now employs derivatives extensively across the portfolio.

HOOPP’s Keohane says derivatives consistently get a “bad rap” in the press, but says “they’re just a tool”.

One example of how the fund uses derivatives is in its credit portfolio. It saw Canadian credit as being overpriced and so by using credit default swaps the fund could reduce risk by diversifying its credit exposure. Now, most of its portfolio exposure is through derivatives.

Many academic papers, such as those by the Alternative Investment Research Centre at the Cass Business School in London, use scenario-based asset-liability model to study the impact of different interest rate derivatives on the risk-return profile of a defined benefit fund. The results show that properly constructed hedging strategies using swaps and swaptions can add substantial value.

The literature on the use of derivatives has increased of late, in line with the increasing attention being paid to risk management and portfolio efficiency. In addition, groups such as the UK’s National Association of Pension Funds (NAPF), have published guides to the use of derivatives.

Much of the hesitancy around using such instruments has been around complexity and transparency, but also the regulatory treatment of the instruments.

Academic studies, such as that by Meije Smink at the department of finance at Erasmus University in The Netherlands, show that derivatives can substantially alter the risk and return profile of portfolios, but that the relative attractiveness of derivatives depends on the regulatory treatment.

That argument is still alive and well. In Europe, for example, the proposed changes to regulation of derivatives, and subsequent impact on pension funds, actually goes some way to support the argument against using the tools on the basis it all seems too hard.

In the wake of the financial crisis, the new European Market Infrastructure Regulation will dictate that the majority of deals will have to be cleared through a central counterparty, and assets will need to be pledged as collateral.

NAPF, which has 1,200 pension funds as members representing about €1 trillion, has published a position paper outlining concerns over the proposed regulation and the impact on pension schemes. It is arguing that pension funds should have the “non-financial counterparty” exemption available to their corporate sponsors.

The objections relate to the potential impact on schemes’ investment returns, and so the affordability of pensions, the increased operational risks, including risks to scheme assets put up as collateral, and the likely reduction in opportunities for schemes to access non-standard derivative contracts that more exactly match their long-term pension liabilities.

Similarly on the other side of the Atlantic, a bill has been introduced to delay the deadline for implementing Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Scott Garrett, chairman of the House Committee on Financial Service’s Subcommittee on Capital Markets and Government-Sponsored Enterprises, says Dodd-Frank set up a totally unrealistic and unworkable timeline for the implementation of a massive and bifurcated new regulatory regime to oversee the US OTC derivatives markets.

“If the regulators get this wrong, it will be difficult – if not impossible – for businesses of all shapes and sizes to responsibly hedge their risks, and trading will be forced off of US markets to those overseas. Without this legislation, the rulemaking process will be unnecessarily rushed – we are ensuring that regulators have enough time to get this right,” he says.

Derivatives are complex and difficult to trade and so getting regulation right is important, of course. But the right tools will always go wrong when they are in the wrong hands; but within the context of institutional investment management it shouldn’t be unreasonable to expectlarge pension funds to be sufficiently equipped to handle those tools.

As HOOPP’s Keohane explains: “You can do woodwork with a hand tool, or you can use a radial-arm saw which is very precise, but if I’m not trained I could cut my thumb off. This is like using derivatives, if you are properly trained it is more efficient in time and cost. Suggesting you don’t use derivatives is a giant step backwards.”

More detail of HOOPP’s approach will be revealed in next week’s Investor Profile