Institutional investors are moving away from the use of complicated derivatives strategies that don't serve a direct investment need, figuring the potential for problems is greater than the probability for gain, industry experts say.
Instead of looking at a derivative or derivative strategy and asking what it can do, investors are looking at their portfolios and asking what investment goal or purpose a derivative can serve.
The change in attitude follows a deluge of losses through derivative-associated strategies reported at big institutions, such as Barings PLC, Orange County, The Common Fund and the State of Wisconsin Investment Board.
The pension fund for Eastman Kodak Co., Rochester, N.Y., might be the most notable example of how investors are stepping back from derivatives use. It recently overhauled its manager lineup, severely cutting back on its employment of returns-focused derivatives strategies (Pensions & Investments, July 10).
Even some money managers are trimming back on their derivatives use, or don't want to be known as derivatives managers. Some firms that use derivatives or have in the past, declined to be included in P&I's accompanying derivatives directory. Some firms widely known for their derivatives use, such as Bankers Trust Co. and J.P. Morgan Investment Management Inc., both in New York, did not respond to the survey.
Certainly, derivatives use will continue, and will grow with the markets, but perhaps with less aggressiveness and more forethought, consultants say. Derivatives transactions will be less driven by financial innovation on the part of those selling them, and more driven by providing low-cost execution of strategies and tactics on behalf of the end user.
In the past, investors were trying to fit "a square peg in an unidentified hole. Sometimes it fit, sometimes it didn't," said Narayan Ramachandran, managing director for Rogers, Casey & Associates, Darien, Conn. "Innovation now will be client-driven," he said.
Mr. Ramachandran said the paranoia regarding derivatives is "overdone," and he is seeing signs that pension plan sponsors are beginning to differentiate between using derivatives for hedging and asset allocation and those used to get returns. Even now, he said, some plan sponsors are considering an increase in their use of derivatives, contemplating a collar strategy to try to lock in some of the big stock market gains seen so far this year. (Collars are used to provide downside protection, and are funded by limiting potential upside return).
Heinz Binggeli, managing director for the consulting unit of Emcor, Irvington, N.Y., said that derivative use can't be stopped, simply because they do serve useful roles, such as getting quick access to the returns of an emerging market.
But the more complex structures, involving things such as leverage or those with payouts tied to cross-market characteristics, probably don't have much of a long-term future, he said. The process of "pure engineering and then a sales push, I think that's all over," he said.
Edgar Peters, chief investment strategist for PanAgora Asset Management Boston, said, "The problem with exotic derivatives (is) you can't really see how they'll really behave under extreme conditions," which is when you want to know what will happen. Just about any of the new derivative strategies work with back-tested models, which don't accurately forecast the market, he added. A rule of thumb is to divide the value-added in a strategy based on back-tested data by two, Mr. Peters said.
Scott Lummer, managing director for Ibbotson Associates, Chicago, goes a step further, saying some sponsors are not necessarily avoiding types of derivatives, but are instead questioning whether there is an economic basis for the strategy being executed. "What's the viability of the strategy?" he said.
A strategy that typically goes long one currency and short another, for example: "Does that have a fundamental economic purpose? I don't think so," he said.
Mr. Lummer said he is not necessarily questioning that returns can be gotten in those types of investment arenas, but that it's too difficult to control and measure the risk being taken. "The strategies themselves are so unpredictable. I'm not sure I can predict the risk."
He said that while he might question whether a tactical asset allocation manager can generate positive returns in the long run, it is relatively easy to understand and monitor the risk in TAA. For that reason, he is more likely to recommend a TAA manager than a manager that jumps in and out of various world currencies.
Mr. Ramachandran of Rogers Casey also said he sees a lot of questioning and evaluation of strategies relying heavily on derivatives to achieve returns at the plan sponsor level. Sponsors are studying why they use derivatives more than they're studying the instruments themselves.
Mr. Lummer added that the value of portfolio diversification from derivatives, and from alternative strategies in general, is being questioned by sponsors. While a venture capital investment might provide portfolio diversification, "so does a spin on a roulette wheel," he said. There are correlations to traditional markets in many derivatives and alternative strategies that aren't being recognized. Plus, diversification has diminishing marginal benefits, he said.