UK pension funds need derivatives rethink

Tweet By Sinead Cruise (Reuters)

LONDON | Thu Oct 13, 2011 2:08pm BST

British pension funds must overcome their historic distrust of derivatives, which could protect portfolios from sudden market moves or shifts in economic policy that many schemes are ill-equipped to cope with, advisers say.

The return of quantitative easing has reinforced a case for reform in the way some pension funds are managed, with some critics honing in on the infrequency of trustee meetings to approve asset allocation changes. Analysts also highlight trustees' aversion to the use of swap-based tools or hedging to manage risks like inflation or stock market falls. "The big problem is the concept of selling short ... I have met fund trustees who are uncomfortable allowing managers to sell something they do not actually own or making money because a price goes down," said Gordon Ross, global fixed income manager at DB Advisors, part of Deutsche Asset Management. "But investment guidelines will need to be amended to permit such strategies," he said.

The Bank of England has committed to buy 75 billion pounds of government bonds over the next four months which will depress the yield on this pension fund staple investment, making it tougher and more expensive for funds to match income to liabilities unless riskier, higher-yielding assets are added to portfolios.

But even if trustees accept they need to raise the proportion of higher-risk assets like equities or corporate bonds in their portfolios to meet obligations, many remain suspicious of complementary hedging strategies designed to offset this risk if bets turn sour.

"Just because you are a good long-only manager it doesn't make you a good absolute return manager ... the ability to protect in a down-market is almost as valuable as being able to identify the trigger point to buy in an up market," Ross said.

Despite being responsible for hundreds of billions of pounds of retirement savings, the UK pension fund sector is broadly seen as less nimble than it should be when dealing with bouts of market volatility, which has recently sent deficits soaring. The aggregate deficit of the 6,533 UK pension schemes in the PPF 7800 index increased to 196.4 billion pounds at the end of September, up from a deficit of 117.5 billion pounds at August 31, government estimates show. "Many pension funds review their asset allocation on a regular but infrequent basis; in some cases this can be only once every three years," Mirko Cardinale, Head of Strategic Asset Allocation Research at Aviva Investors (AV.L), said. To demonstrate the need for more flexible and timely management, Aviva constructed two hypothetical portfolios with the typical asset weights of an average UK pension fund in 2001. Over 10 years, one portfolio was managed dynamically, shifting its exposure to equities, fixed income, cash and property in response to changing returns, risk and correlation each quarter while the second rebalanced its allocations annually, in line with typical industry practice.
The dynamic portfolio outperformed the static one by almost 3.5 percent a year, Aviva said. Moreover, the swift rebalancing helped to its reduce overall volatility and lowered the downside risk, with the maximum quarterly loss about 4 percent.

INFLATION - THE NEXT BIG BATTLE?
Shalin Bhagwan, head of structuring in the Liability Driven Investment Funds unit at Legal & General Investment Management said pension funds are running out of time to hedge portfolios against their biggest foe - inflation.

"Inertia is costing people money, definitely. The equity horse has bolted but inflation risk is what people should now be focused on," he said, referring to missed opportunities to use equity options or variance swaps to minimise hurt caused by recent falls in global stock markets. The reluctance to hedge out the risk of a future spike in inflation contradicts the typical pension fund mantra of investing for the long-term and keeping costs low.

"When the world is concerned about deflation, that is the time for a pension fund to start thinking about inflation risk. Right now, the cost of hedging that over 10 years using inflation-linked government bonds is less than the government target (for inflation)," Bhagwan said.

But Saker Nusseibeh, head of investment at Hermes, the manager owned by the BT Pension scheme, said investors must resist making significant risk management decisions on the back of very short-term market moves. "While this momentum has been building under the heading of greater financial sophistication and risk management techniques, it is now being applied with particular alacrity and vigour in response to unprecedented market conditions," said Nusseibeh, who also chairs the 300 Club, an industry body keen to highlight the dangers of short-term reactions to volatile markets. Even with more meetings and flexible investment guidelines, advisers say most pension funds will always have a natural aversion to synthetic tools in tail-risk management strategies. "If you hedge an asset with a short derivative position, upside is zero and that is something psychologically hard to accept for many people," said Alexander Preininger, head of overlay management at DB Advisors.
(Editing by Greg Mahlich)