Leading pension fund and institutional investors believe using derivatives is becoming increasingly necessary to achieve competitive returns.
Their view - part of a wide-ranging discussion on pension fund use of derivatives in a Pensions & Investments roundtable - was tempered, however, with caution and caveats.
One panelist worried the lower cost and efficiency of using derivatives might make some pension sponsors engage in higher-risk strategies than they otherwise would have.
Among the issues the roundtable examined were:
What size pension fund should use derivatives? One panelist suggested a minimum of $50 million in assets.
Should 401(k) portfolios include derivative strategies? Most panelists believe they could be useful, although there was a worry about the impact of daily portfolio switching by 401(k) participants.
Are derivatives the most complex of the array of investments or asset strategies pension funds use? Most panelists suggested they were not, while conceding the understanding of derivative-based strategies is still limited.
An edited transcript of the roundtable begins below. The participants were:
Charles A. Service, corporate director-capital management and trust investments, Unisys Corp., Blue Bell, Pa.;
Robert E. Shultz, senior vice president, The Common Fund, Westport, Conn;
William L. Gurner, who left in January as manager-trust investments, Federal Express Corp., to become president of Sector Capital Management L.L.C., Memphis, Tenn.;
Charles A. "Tony" Baker, vice president, SEI Corp., Wayne, Pa.;
Tanya Styblo Beder, principal, Capital Market Risk Advisors Inc., New York;
Scott Lummer, managing director, Ibbotson Associates Inc., Chicago;
Maarten L. Nederlof, managing director, TSA Capital Management Inc., Los Angeles; and
Lisa K. Polsky, managing director, Bankers Trust Co., New York.
The panelists were interviewed in Chicago by Barry B. Burr and Paul G. Barr.
Pensions & Investments: How big should a pension fund be to use derivatives in a cost-effective manner?
Robert E. Shultz: I would say it's really not a matter of size. With outside managers running a fund, derivatives can be used effectively in any size pension fund.
Charles A. Service: I don't see the use of derivatives as being a function of pension fund size. As a matter of fact, when you consider that a number of smaller pension funds are going to be invested in commingled vehicles that use derivatives, that's a cost-efficient manner perhaps for those funds to operate. Just like any investment, plan sponsors have to understand what it is they are investing in.
William L. Gurner: I disagree, because smaller plans aren't sophisticated enough to make those decisions. The minimum size should be around $50 million.
Scott Lummer: We tend to relate size and sophistication, and that can be problematic. Some of the bigger plans and bigger investment entities should not have been investing in derivatives because they didn't understand them. It had nothing to do with being cost effective. But I guess I have to agree with Charles; it might actually be more beneficial for some of the smaller plans to get invested in some of these strategies with derivatives because the transaction costs of getting into the base instruments would eat them up.
Charles A. "Tony" Baker: Some of the smaller corporate plans very often are very sophisticated because they use them quite frequently on the corporate side.
P&I: Would another lackluster year of performance in stocks and bonds increase the incentive for pension funds to use derivatives?
Lisa K. Polsky: We're confusing investment strategies with delivery vehicles. Derivatives are a delivery vehicle. You can use a derivative to structure risk/return in a number of different investment strategies.
A lackluster year would cause people to use derivatives because it's easier to structure risk/return trade-offs. Risk has certainly gone up in 1994 compared to 1993 and return has certainly gone down, so having the ability to structure risk/return would be more useful than not having that ability looking forward.
You'll see increasing use of diversification of investment strategies. You'll see people looking at non-traditional asset classes, like market neutral, hedge funds and perhaps volatility trading.
Mr. Shultz: Derivatives came into existence for hedging purposes and largely should be looked at as a risk control measure, not a return enhancement. I'm not comfortable with people talking about derivatives enhancing returns except through the efficiencies of lower transaction costs.
Mr. Lummer: We can't deny one thing, that derivatives open up the doors to a lot of fund managers and a lot of plan sponsors to get into risks that they otherwise would not have gotten into, and that's something we have to recognize. Yes, it is possible - without investing in derivatives - to get into those same type of risks, but some of those plan sponsors and some of those managers never would have gotten into that.
There is more pressure to increase return with derivatives. There is the incentive to get into these contracts by the very types of people who should not get involved with these contracts, the people who really don't understand what they're getting into. That's what I think we've seen come crashing down in the last year, and I think we'll continue to see that.
Tanya Styblo Beder: It would be very difficult to achieve competitive returns in the marketplace today without having some type of derivative strategy. And, again, you have to be careful - not all derivatives should be lumped together. There are clearly derivatives that have toxic waste-type returns attached to them; certainly we've seen some of those come out in the public arena. But when you take away that category, much the same way as you take away the toxic waste portion of other financial instruments, they provide a very valuable role certainly in terms of even diversifying patterns of return.
Along with the ability to manage and diversify your risk, there is also the ability to manage and diversify your returns and, for example, achieve patterns of return that are not available via classic investment vehicles and may match liabilities a great deal better.
Mr. Shultz: My firm is putting a lot of emphasis on absolute return strategies as opposed to the traditional focus on relative returns. By that I mean hedge funds and market neutral and other investment strategies that don't depend on taking a position on the direction of markets. This is based on our view that the capital markets will generate lower returns for the balance of the '90s because of reversion to longer term and lower mean returns.
And to the extent that many of those strategies use derivatives, yes, we will be focusing on them.
But our first approach is not that we expect lower returns, therefore, we're going to use derivatives. It's that we're looking for strategies where we can generate adequate returns from, in essence, non-directional strategies.
Mr. Gurner: I think at a minimum plan sponsors would look more aggressively toward these things.
Mr. Service: I have just one other thought, which is defining what a lackluster year is for a corporate pension fund.
In 1993, most pension funds earned good absolute returns. Interest rates went down, however, so funding surpluses shrunk, and sponsors had to pour money into the plans.
In 1994 no plan made its actuarial return assumption. But rates went back up. Surpluses expanded. Sponsors didn't have to put as much money into the plans.
P&I: Because your liabilities fell?
Mr. Service: Exactly. So you have to consider "lackluster" within the framework of what a corporate pension fund sponsor is looking at and the knowledge that you're trying to manage our asset pools and meet our liability obligations.
P&I: Is there any kind of regulation you can envision that would help ease the risk of derivatives or enhance their use?
Mr. Baker: The answer is no. You're not going to prevent what has occurred. People shoot themselves in the foot with stocks all the time. What's needed is a greater knowledge.
Ms. Beder: The answer lies far more in greater disclosure and better transparency in terms of how the structures are created than it does in regulation.
P&I: By transparency you mean?
Ms. Beder: Actually providing to people who purchase derivative transactions the pieces so they can not only calculate the cash flows at a point in time for the exit values, but so they can gain an understanding of the embedded leverage or the costs.
Maarten L. Nederlof: Ultimately a dealer selling something to a client needs to understand the client and their intentions, and for that matter it may require them to disclose more information about how a particular instrument will move over a series of market moves.
Mr. Lummer: Any regulation that we know of in the financial markets comes at some degree of cost, and to further regulate derivatives would cause tremendous lack of flexibility, would increase risks in a lot of markets and wouldn't accomplish near what the objective would be and would increase costs tremendously in these capital markets.
Ms. Beder: If you look at the losses in the market last year - losses like Metallgesellschaft AG and Askin Capital Management -they actually involved a great number of exchange-traded instruments, and those are very heavily regulated markets.
P&I: Would some sort of limitation on the use of derivatives have made sense with such losses as Orange County?
Mr. Lummer: No.
Mr. Shultz: It's leverage that has created many of these problems. I think there is an immediate assumption when you use the word derivatives you are talking leverage, and that's not necessarily true. They are two different issues.
Ms. Polsky: The other issue is the mark-to-market issue. People carry investments that they look at as high-yield investments and say well, I think the probability of the outcome is very low, therefore, I think I am going to earn this higher yield and I am going to account for this higher yield today. That's not a mark-to-market approach to accounting for your investments. The mark-to-market approach says every day what is the probability of the event. You have to mark to that probability.
Mr. Nederlof: I'd say 90% of the use of derivatives is for hedging purposes, which is really where you are trying to reduce risks. If you prohibit their ability to hedge some of the risk forces, you're probably creating greater concerns in other areas.
Mr. Shultz: The other thing to remember: if you're a hedger and everything works well, the hedge is going to lose money. But did it serve the hedger's purpose? Yes, it did.
P&I: It's like complaining about the cost of your auto insurance.
Mr. Lummer: Right. And saying it was dumb to insure because I didn't have a loss. Therefore, I lost money by insuring.
Mr. Gurner: There are some definite weaknesses, though, in these over-the-counter issues, as opposed to exchange-traded issues. There should be better disclosure.
P&I: We kind of see this question related to the issue of lackluster returns and how vital it is for a fund to use derivatives to achieve competitive returns.
Ms. Beder: Derivatives add a tremendous benefit. For example, for smeone who wants to gain exposure to a foreign market - rather than having to research individual stocks, one can take a position (continued)