Whereas with the derivative transaction: "Oh, well, these are complex, I didn't understand them." But the reason people lost money was because their bet on interest rates was wrong. Interest rates moved further faster than most people expected, so what people thought was not probable became probable. Derivatives are a vehicle through which the strategy is implemented.
Ms. Beder: And the amount of money lost on just holding simple pass-through mortgage securities swamps what was lost in engineered mortgage securities in the last year.
I've had meetings with funds where they'll pull out a portfolio with thousands of securities. They'll ask if I could take a look at the four derivative positions and tell them what they should do because, God forbid, they should have a loss due to the "D" word.
So I take a look at those four positions and they are very de minimis in the context of the pattern of returns, and I would observe, "Well, maybe you should focus on the coupon mortgages in this portfolio instead of the derivatives because volatility is going to go to the moon here."
And they say, "Yes, yes, that's very interesting, but what about these four derivative positions?" I think that's indicative of the phobia that people have sort of adopted vis-a-vis the derivatives sector of the marketplace. A loss is one thing, but a derivatives loss is entirely different.
Mr. Shultz: I would be much more comfortable if the term was derivative instruments, so that we are not implying an asset class. They are merely instruments that allow you to take positions.
Mr. Gurner: I think it's the people and not the derivatives. Everybody wants to outperform the other guy and everybody is very competitive. Also, I think the policies of the governments and the corporations are very weak to control situations like this.
P&I: Pension funds give hedge funds a wide latitude in investing in different asset classes. Does it make sense to pigeonhole some equity managers into certain specific areas, while giving a hedge fund a broad latitude?
Ms. Polsky: I think increasingly what you're going to see in asset allocation is rather than looking at traditional asset classes of equity, fixed income, you are going to be looking at risk buckets and how do you allocate your risk capital among the various risk buckets and what's the volatility of each bucket and the correlation of the risk buckets.
Looking at traditional assets, as soon as you hire an active manager, what you've essentially done is attach a piece of a hedge fund to an index fund. And you could strip off the alpha or the trading of every active fund manager and put them into a bucket that you call hedge funds.
Mr. Nederlof: Sources of alpha.
Ms. Polsky: Sources of alpha, exactly. And then you would take that bucket of alpha and break it down into the risk buckets and then look for the return that I am getting relative to the risk that I am taking for each of those buckets.
P&I: Will managed futures managers ever be able to grab a share of the pension market? And should they be considered a separate asset class?
Mr. Service: If you are talking about a significant share of the pension fund business, I would say not. Real estate investments have been around in the institutional sense for, what, 20 years, and it's still not meat and potatoes. It's hard for me to imagine that managed futures is going to go and be much more than that; it's the parsley off to the side.
P&I: Would you say how large relative to, say, real estate?
Mr. Service: If it took real estate 20 years to get to this point where it's still a single-digit type of allocation in the median pension fund and has no representation in a good portion of pension funds, I can't see managed futures doing better than that any time soon as an asset class.
Mr. Baker: Under the way managed futures is normally understood by pension funds, I would agree with that. However, there is a different view that is coming out that I think will allow it to gain a more significant portion. Even most of the industry does not even realize that fundamentally what they are doing is providing a risk transfer service to commercial hedgers. You are buying the volatility that commercial hedgers want to get rid of and you get paid for that.
Now, most people invest in managed futures actively and will tell you, and the industry will also tell you, that the reason they generate returns is because of their great skill.
In fact there is an inherent return in this market that comes from providing risk transfer and it doesn't require manager skill, although manager skill can exist in those markets just like it can exist anywhere else. But returns exist independent of manager skill, and don't require the high fees they normally charge, and can absorb a significant amount of money.
What's been missing in the institutional climate is this economic rationale. For a pension plan sponsor to take on managed futures when it's based solely on manager skill is a very difficult thing to present to any board. But to have an economic rationale that there is inherent return, just like there is inherent return in the stock market, that's a much more palatable argument.
Mr. Lummer: I agree with Tony to an extent. I think he is absolutely right that the managed futures market has to some extent mismarketed itself, always tried to market itself on alpha and not tried to market itself on the basis (continued)
