Alternative Solution

An alternative way of resolving this misalignment is to keep the benchmark unchanged and equity weightings high in order to benefit from rising markets, but to use derivatives to protect against a rapidly falling equity market. Sadly, at this point in time, few trustees understand derivatives, whilst many believe that they are an efficient means of losing large amounts of money, rapidly. Fund managers for pension funds must convince trustees of the benefits of derivatives, but in the past this has proven to be a difficult task, unless a suitable approach is taken.

Suitable Approaches

Often the first question that pension fund trustees ask of their fund manager is "Just why do you want to use derivatives ?". The answer should be couched in terms of the quantifiable benefits that the fund will obtain, not just couched in terms of ease of implementation for the fund manager. For example, it is more important for the trustee to be told that using derivatives to change the allocation of the fund's assets reduces the cost of such changes, rather than to be told that it helps the fund manager to implement a decision more quickly. The fund manager might believe fervently that separating the asset allocation decision from the stockpicking decision reduces the disruption to portfolios, but trustees do not have any remit to help make the life of a fund manager easier!

Giving concrete examples of such cost savings is vital. At the time of writing, in the UK stock market, transactions suffer fifty basis points of stamp duty - a tax on investments which is not suffered by the futures market. Even if only one transaction is done per year this saving will improve the performance of the fund by the equivalent of that fifty basis points. In the intensely competitive world that is pension fund management, wherein many fund managers align their investments with the median fund and so obtain very similar results, fifty basis points is a significant improvement in performance.

The next approach that a fund manager should take is to outline what strategies have been undertaken for other pension fund clients. Trustees never want to be the first to adopt new strategies but neither do they want to be seen to be the last. A recent survey in the UK by the National Association of Pension Funds revealed that 52% of UK pension funds are now permitted to use derivatives, up from 47% a year earlier. This means that any pension fund that does NOT use derivatives is already in the minority. One pension fund manager has obtained agreement from clients in recent months to use futures contracts for asset allocation purposes by pointing out to clients that "our other trustees allow us to do this and if we had been able to do it for you, we could have got X basis points extra performance."

Throughout all this process however, it is vital to educate the trustees. Too often the good points of derivatives are emphasised and some form of "free lunch" appears to be on offer. Trustees should be told what strategies a fund manager wishes to employ, why he wishes to employ them and what would be the potential disadvantage to the fund if the strategy adopted is incorrect. That education should be continued once a strategy has been adopted by the fund manager outlining the similarity between the theory that he had previously explained and the practice that had actually taken place.

One example that is easily understood by trustees is the use of derivatives in a takeover situation. Company A makes a bid for Company B. The announcement of the bid will probably result in a sharp rise in the share price of Company B and an associated "windfall profit" for any pension fund which was holding those shares. However the decision to purchase the shares of Company B might have been made as part of a long term investment strategy and the fund manager may wish to support the management and therefore vote against the bid. Sadly in doing so, at least in the short term, he is "poisoning his own soup" because, if other fund managers take that view and the bid fails, the share price is likely to drop back to earlier, lower levels. The fund manager can however resolve this difficulty by buying out-of-the-money put options on the shares of Company B, using some of the windfall profits to pay for the premium. He can then safely vote against the bid, knowing that if it still goes ahead he has obtained most of the benefit of the rising share price but avoided any subsequent fall in the share price if the bid fails.

That is a practical example that trustees can recognise and with which they have much sympathy as often, in practice, they do want to vote for the incumbent Board of Directors.

One of the main fears of trustees seems to be that, if they give the fund manager permission to use derivatives, then these strange instruments will come to dominate the portfolio and that the fund manager will be wheeling and dealing at all times of day and night. The fund manager has to emphasise a number of points. Firstly that he only intends to use derivatives to execute decisions that he has made anyway, but that he can implement more efficiently by using derivatives - such efficiencies might be in terms of saving costs or time. Secondly, the fund manager should emphasise that he is not going to want to use derivatives always, but only when the need arises and that he doesn't want to then spend three to six months getting permission from the trustees. Thirdly, the fund manager should emphasise that he will provide reports to the trustees on what he has done, why he has done it and what the benefits to the fund have been as a result. Theoretical reports should be shown beforehand and actual reports clearly explained afterwards.

Fund managers must assure trustees that they can, if they desire, put limits on derivative usage, either in terms of frequency of dealing or size of transaction. Indeed at the beginning, it is often good practice to ask trustees to authorise transactions on only one or two percent of the fund in terms of underlying exposure. Once the fund manager has shown the trustees that he can use these instruments in a sensible way and can demonstrate the benefits, he can subsequently request an increase in these limits to ten percent or even more.

However, it is not appropriate for trustees to request that a fund manager ask permission for each individual derivatives trade before it is undertaken - this is not a practice which trustees adopt for equities or bonds and therefore they should not expect to have different standards for derivatives.

It cannot be overemphasised just how important is the education of trustees in derivatives. A recent UK Pensions Bill stopped short of requiring all pension funds to have an independent trustee, but did put a greater onus upon trustees to be professional in their responsibilities for the fund. The National Association of Pension Funds (NAPF) provides a number of courses for trustees to give them higher levels of knowledge on the investment markets. The Association also provides a course on the use of derivatives in pension funds. Fund managers should certainly recommend that trustees attend one of these courses. Such promotion of derivatives by the NAPF is a positive addition to the fund manager's influence with trustees.