in an index-based derivatives contract.
Mr. Lummer: If there is something unique that you can do with derivatives that you can't do with the underlying, then it's probably something that is increasing your risk exposure tremendously, because we've seen time and time again that nothing happens for free.
Mr. Service: For the most prevalent uses of derivative instruments, it is not vital for a fund to use derivatives to achieve competitive returns.
Mr. Gurner: Going back to the question about the lackluster performance in stocks and bonds: That's how people are selling these investments, that you will not get the returns from traditional investments in stocks and bonds. So in order to be competitive, you're going to have to move into futures or hedge funds, and that's a little bit misleading depending upon the actuarial assumption of the pension plan.
Mr. Lummer: The key word in this question is vital.
Mr. Nederlof: Oh, no, I would agree, it's not vital.
Mr. Service: Useful, but not vital.
Mr. Baker: Beneficial. (Mr. Nederlof and Ms. Polsky agreed.)
Ms. Polsky: It may, however, be vital to use derivatives to control your risk going forward.
All of this focus on enhanced return is very misleading, because you enhance your return, you have enhanced your risk.
But you can package risk to enhance return without significantly increasing volatility, and I also think you can use derivatives to hedge particular risks that are not appropriate to your portfolio, thereby reducing the total volatility of the portfolio.
So it may not be prudent going forward in a sense to not use derivatives.
P&I: So you're saying it is vital to use derivatives to manage risk?
Ms. Polsky: Yes, relative to managing risk. Absolutely.
So I think it would be imprudent not to look at the information in the derivative markets in a forward-looking sense, and that you can be more dynamic in the management of your portfolio.
Mr. Nederlof: I think that's an important point, which is that your horizon does come into play here. Derivatives are very, very helpful and maybe even vital if you are concerned about your performance over a short period of time. But if you are a fund that has a particularly long point of view, I'm not so sure it's vital.
Ms. Polsky: Most funds have a different horizon for different asset classes. For U.S. equity a lot of funds can take a very long-term view, but for emerging markets it's a shorter term view because the volatility is so much higher. However, what prevents people from allocating more of their assets to emerging markets is the short-term volatility, and so if there is a method of managing the risk that allowed you to be in for the long-term - management of short-term volatility that allows you to be in for the long term - it's beneficial long term for the fund. That you can achieve with derivatives and you cannot achieve through traditional investments.
P&I: How much, if any, blame should derivatives get for the losses, such as Askin Capital Management and Orange County?
Mr. Lummer: You have to link in almost every case we've seen in the popular press the use of derivatives and leverage. The single thing that makes derivatives risky to the "unintuned" observer is their built-in leverage aspect, the ability to generate huge losses with relatively small market movements, whether it's in a linear or non-linear fashion.
So as to which deserves more blame - is it the derivatives, or is it the leverage, or the leverage built into derivatives - is somewhat of an academic question. The point is both in combination can dramatically increase the volatility of a pension plan or a corporate balance sheet, and if not managed properly can cause great damage.
Mr. Nederlof: It's not an issue of derivatives.
Ms. Beder: I would be very concerned about linking leverage with the word derivative. That is a very small class of the derivatives market in general, and I would argue only a few percent of the transactions that are done. It would be a tremendous disservice to people to think that if you do derivatives you are engaging in leveraged transactions because that's far from it.
Mr. Service: But that is indeed what is happening, of course. Most people incorrectly believe all derivatives usage incorporates leverage, because of the stories they read.
Ms. Polsky: People have lost a lot more money in 1994 on betting on interest rates incorrectly and blaming it on securities than they have on betting on derivatives.
It's easier to point to the derivatives. If someone says, "I lost $2.5 million in my two-year note portfolio," it's hard to get a lot of tears and sympathy, and it's very hard to sue the U.S. government for your losses to your note portfolio.
