While virtual reality might still be in its infancy, virtual investing has taken hold and is thriving in North York, Ontario.
Virtual investing, or investment through derivatives, has allowed the Ontario Teachers' Pension Plan Board to transform its entire portfolio of primarily $18 billion (Canadian) in non-negotiable government securities into a C$34 billion globally invested portfolio of stocks and bonds.
At the same time, the fund increased its diversification and boosted returns.
The board uses derivatives for a reason. It inherited C$18 billion - about $13 billion in current U.S. dollars - in non-marketable securities when the pension board was created in 1990. Since then, the staff has worked to use derivatives to diversify its portfolio within and outside Canada, and to keep investment returns in pace with benefits that are indexed to inflation.
As a result of the fund's use of derivatives, Ontario Teachers' asset mix is 60% linked to the return on equities - including some real estate and venture capital - and 40% linked to fixed income, said Robert Bertram, senior vice president.
Mr. Bertram joined the pension board in October 1990. That was the year provincial legislation was passed that allowed the fund to diversify out of Ontario debentures to help boost funding levels of the fund. The Ontario Teachers' Board was created to administer and manage the plan under its new investment mandate.
Mr. Bertram said it was his intention when he interviewed for the job to use derivatives to follow the mandate.
Indeed, the plan's first derivatives trade was a U.S. Treasury long bond futures position in February 1991, Mr. Bertram said. And while the fund still has C$16 billion of Ontario debentures lodged in its portfolio, the fund regularly swaps out of those fixed returns into equity index returns and floating-rate returns. The board's staff also combines short futures positions with its debentures to create effective exposure to short-term rates, limiting the fund's interest rate exposure.
As of the end of last year, its fixed-income investment effectively was reduced to C$18.1 billion from C$21.8 billion, while its non-Canadian equity investment was boosted to C$7 billion from C$3.4 billion.
In addition, the fund's use of over-the-counter derivatives has grown this year, and is expected to grow next year. Morgan McCague, vice president, core portfolio, who works with the board's equity derivatives, said the plan's equity swap transactions this year might be double what they were last year, and could triple in coming years.
Equity derivatives can be done faster, cheaper and with no market impact compared with cash equity investments, Mr. McCague said. Commissions, custodial fees and foreign investment taxes all are reduced.
Ontario Teachers has C$4.5 billion invested in U.S. equities, all of it through derivatives, Mr. McCague said.
"They're very progressive ... they've done a great job," said William F. Chinery, principal for William M. Mercer Ltd., Toronto, in reference to Ontario Teachers. Mercer has provided some project assistance for the plan unrelated to derivatives, according to Mr. Chinery.
Derivative use at Ontario Teachers and other Canadian funds has been encouraged by a Canadian tax ruling that no more than 20% of a fund be invested outside of the country. Pension funds, as well as mutual funds, get around that by investing in Canadian securities and swapping out of that return, Mr. Chinery said. As long as the underlying investment is in Canadian securities, Canada's taxing authority considers the swaps to be Canadian investments.
And the Ontario Teachers fund has an additional incentive over other Canadian institutions because of the non-marketable Ontario government bonds it owns, Mr. Chinery said.
While a portion of those bonds mature each year, none of what the fund has done could have been possible in that short amount of time without the use of derivatives, Mr. McCague of the teachers plan said.
Using OTC transactions and exchange-traded futures and options, the Ontario Teachers' staff has swapped out of much of the returns of those securities for both floating-rate returns and equity index returns. The fund also uses short futures positions to adjust its fixed-income duration, a measure of interest rate price sensitivity.
For example, at year end, the Ontario Teachers fund had agreed to swap the fixed coupon payments on C$5.2 billion of its non-marketable securities for the return on C$1.5 billion of floating fixed-income investments and C$3.7 billion of equity investments. While C$5.2 billion is the notional amount swapped, the actual dollars changing hands would be much smaller, amounting to the return on a notional amount of securities for the given time period.
But in creating these positions, the plan's staff faces questions as to the creditworthiness of counterparties it deals with in OTC transactions, which markets to invest in with derivatives, and how to account for all of its derivative positions.
"We try to manage credit risk properly," Mr. Bertram said. "It's not a perfect process," but no one has it down completely yet.
An oft-stated concern about OTC transactions is that an investor's counterparty could fail, leaving the investor with an exposure it didn't want, and perhaps a loss of profits from the position.
Mr. McCague said OTC investors have to select counterparties "with extreme care. ... It takes a while (for Ontario Teachers) to do a first deal with a counterparty," he said. Most of its counterparties are AAA rated by ratings agencies, he said.
Board staffers have to feel the counterparty will add something to the investment process, Mr. McCague said.
Similarly, the fund's staff will only use derivatives in markets liquid enough to keep costs low.
Although Mr. McCague said the plan is "prepared to look at just about anything," if pricing is out of line on derivatives in a particular market, the plan will stay away. Hong Kong derivatives, for example, is an area the plan isn't interested in because of relatively higher pricing, Mr. McCague said.
"There's no magic in it" and pricing tends to be a reflection of liquidity, Mr. Bertram said. Ontario Teachers wants to stay in liquid markets.
Accounting for derivatives has required education for the staff, but Mr. Bertram said the board has some "quick learners." He said he considers his staff to be on the leading edge of being able to account for derivatives, which require a somewhat different perspective.
"Opportunity cost is important," Mr. Bertram said. Accounting for derivatives requires an understanding that while an investment's opportunity cost is always an issue in investing, derivatives make opportunity costs explicit. For that reason, it is critical to understand what relationship a derivatives portfolio has with the rest of the portfolio, he said.
In addition, Mr. McCague said the plan has developed internal management systems that make "quick and accurate" profit and loss positions available to the plan's staff.
While Mr. Bertram declined to say what the plan's returns have been, he did say the returns have been "quite attractive compared to other pension funds."
According to Ontario Teachers, 1993 annual report, the fund returned 21.7% in 1993, while the portfolio returned an annualized 13.8% since diversification began in 1990.
While the Ontario Teachers foray into derivatives investment hasn't led to any big surprises - the intention was to build a more diversified plan - the ability to do transactions in various markets and liquidity of the swaps market are greater than he initially thought they would be, Mr. Bertram said.