Leading Canadian and Dutch public pension funds have engaged in what is believed to be the first-ever direct equity swap between two pension funds.
The Ontario Teachers' Pension Plan Board, Toronto, and Stichting Pensioenfonds ABP, Heerlen, the Netherlands, have engineered two swaps of the Toronto 300 index and the Dutch AEX index, respectively, with a total value of $60 million.
Under the swaps, the Ontario teachers' fund receives the total return of the AEX index, while ABP receives the Canadian stock index return.
By not using an intermediary, the funds avoided brokerage commissions, market impact costs or swap spreads. Andre van den Berg, U.S. representative for ABP Investments in New York, said cost savings are estimated at 25 basis points over the cost of doing the deals with a broker-dealer.
ABP is the world's largest pension fund, with 272 billion guilders ($133 billion) in total assets.
In addition, the swaps helped the teachers' fund raise its international exposure without running afoul of the 20% cap on foreign investment imposed by Canadian law. Through use of previous swaps, the C$55 billion (U.S.$39 billion) now has a nearly 40% foreign exposure.
Officials at the Canadian fund have been using swaps since the early 1990s as a way to increase non-Canadian exposure. With Canadian equities comprising only 2.3% of the Morgan Stanley Capital International World index, it was imprudent to keep 80% of assets invested at home, said Leo de Bever, vice president of research and economics for the teachers' system.
The fund has come in for criticism in the past, however, for what is perceived to be its efforts to circumvent the spirit of the law. But officials have not been forced to undo any previous swaps, Mr. de Bever said.
Use of derivatives started as a way to increase the fund's international exposure without changing ownership of the underlying securities or creating negative international capital flows, he said.
Officials at the Ontario fund originally had started swapping returns on special non-negotiable Canadian debentures into U.S. Treasury securities, and then into equity indexes -- only to later realize they could cut out a step in the middle.
The latest swaps continue efforts by fund officials to cut costs. Ontario Teachers officials theorized they could save money by eliminating the intermediary in a swaps transaction.
But finding a counterparty wasn't easy. Trying to promote the idea during a trip to Europe last year, Mr. de Bever said he experienced a "frustrating" series of visits with Swiss and Dutch pension funds until his last stop at ABP's offices.
There, his proposal was welcomed immediately. "It has to start at the top, with people wanting to do things better," Mr. de Bever explained.
Key to making the deal work was that both parties had similar interests, he said. Both funds have experienced dramatic growth and had launched major investment programs into equities, both domestic and international.
For the Ontario teachers, assets have nearly tripled during the past six years, while the fund's asset mix has gone to a 75% equity exposure from a 100% bond exposure.
Meanwhile, the giant Dutch civil servants' fund is in the midst of a program to boost equity investments to 30% in 2000, more than double its 1995 level of stock investments. Total equity exposure reached 21% by the end 1997, while international equity comprised 11% of total assets.
In addition, both funds are based in countries with relatively small stock markets.
Mr. van den Berg said in a statement: "There was a perfect symmetry between OTPPB and ABP objectives: both sides wanted to decrease their overweight to domestic stocks.
"When Leo de Bever approached us with the idea, we immediately got interested. A direct swap allows us to reduce our Dutch overweight and get exposure to the Canadian market without paying commissions, risking market impact, or incurring swap spreads."
While savings over doing swaps with a broker-dealer were estimated at 25 basis points, they would have been even higher if either fund had first sold off domestic stocks and then reinvested in a foreign market. Mr. de Bever said market impact costs would have been at least another 50 basis points at either end of the deal, on top of commissions.
As a result, the two funds have entered into two swaps of roughly $30 million each, the first occurring last November with a second in late January.
Mr. van den Berg said ABP officials would consider doing similar transactions, but it is "not something we are explicitly looking for right now."
Officials at the Ontario teachers fund are keen to do other deals. Unless the Canadian government lifts restrictions on foreign investments, fund officials will have to replace existing swaps as the Canadian debentures, whose returns have been swapped, largely will mature by 2010.
"There should be lots of foreign pension funds that have symmetrical needs," Mr. de Bever said. The direct equity swap deals are "the trend of things to come."
Tanya Styblo Beder, principal at Capital Markets Risk Advisors Inc., New York, said the deal represents "a natural evolution of a market." As new markets gain more participants, and opportunities to advertise trades on the Internet and elsewhere increase, "we will see more deals like this," she said.
Similarly, pension funds have become direct participants with private placements and block trades, she noted.
Ms. Beder said the funds' estimate of savings on the spread was on the high side.
Other experts, not associated with the deal, thought the potential for pension funds to engage in direct swaps is limited.
Don Ezra, head of European consulting at Frank Russell Co., London, noted both funds are "advanced thinkers and both have the capital to do these (kind of deals)." Russell officials questioned, however, whether small spreads would encourage many others from following suit.
Gareth Derbyshire, vice president with Morgan Stanley, Dean Witter, Discover & Co., London, said: "One of the issues is it's going to be hard to find another party who needs exactly the opposite position as you."