Fri, 28/01/2005 - 06:11
In this article Eurex outlines the case for the use of derivatives within pension fund portfolios with examples of how to build derivatives into traditional portfolios.
Diversification into hedge funds and FoHFs is one solution to the global pension fund crisis; efficient pension portfolio management through derivatives is another.
As widely reported, the pension fund industry has been suffering due to negative equity returns and low interest rates, leading to a serious under-funding of company pension plans.
The general response to the situation from the pension fund industry has been two-fold. Many funds have reduced their equity investment allocation in favour of fixed income investments that more closely match their liabilities. Others have begun to invest in hedge funds and fund-of-funds. The theory is that by investing in absolute return investment strategies, pension funds benefit from increased alpha and portfolio diversification by having exposure to asset classes that have a low correlation with the traditional pension fund investments of equities and bonds.
But will absolute return investment strategies be able to absorb the huge inflow of capital coming from the pension fund community? Undoubtedly, returns will decline relative to the returns of traditional investment classes, as capital inflows from the pension fund community increase. In addition, the current diversification needs to be analysed in terms of the cost implied by higher management fees and percentage of returns as a performance fee. Moreover, most pension funds tend to invest via a fund-of-funds that charges additional management and performance fees.
Therefore, perhaps pension funds should also consider the use of derivatives within their existing traditional portfolio. A recent survey entitled Facing the Future: a survey of derivatives in fund management, found that more than half (52.5%) of those fund managers surveyed stated that they did not use derivatives. However, the usefulness of incorporating derivatives into portfolio risk and asset management cannot be over-emphasised.
This view is supported by Ros Altman, adviser to the Myners Review on Institutional Investment, 2002, and a leading authority on the UK pensions industry.
Speaking on the role of derivatives in pension fund management, she said: "Derivatives allow fund managers more freedom and flexibility to apply their talents, reduce the risk of making mistakes, and allow them to be corrected more easily. If modern methods of money management are available, why should managers choose not to use them? The key, of course, is to know how to use them properly and this is a skill that needs to be acquired. Pension funds need to be concerned about minimising downside risk and also about matching liabilities, not just about maximising returns. This means that derivative strategies can significantly assist in achieving pension fund objectives by allowing closer matching of asset and liability profiles."
Eurex's wide-ranging product offering facilitates risk management and the generation of alpha in both fixed income and equities for the pension fund manager. The exchange lists fixed income futures and options that cover the whole of the European and US (through EurexUS) yield curves.
In addition, national, pan-European, sector and global equity index futures and options, as well as European and US stock options are covered.
Table One summarises some of the potential uses of exchange-traded derivatives in pension fund management.
Most of Eurex's products are highly liquid instruments, which allow the pension fund manager to quickly and efficiently establish and close a derivatives position. For example, with a minimal cash market impact, a combination of equity and fixed income products can be executed to synthetically exit European equities and enter into European government bonds by way of a derivatives transition strategy (see table two).
Apart from being able to use Eurex derivatives to facilitate changes between asset classes, the pension fund manager can use them as an overlay to quickly increase (or decrease) the exposure to an investment class. This strategy is particularly attractive for the pension fund manager as it leaves the existing portfolio intact and uses a smaller capital outlay to the cash market alternative.
Table Two looks at using futures to facilitate a change in asset allocation, while Table Three analyses how Euro-Bund futures can be used to adjust portfolio duration, and Table Four outlines how the Dow Jones EURO STOXXSM 50 index futures can be used to adjust portfolio beta.
While diversification into hedge funds and fund-of-funds absolute investment strategies is one solution to the global pension fund crisis, efficient pension portfolio management through the use of derivatives is another. In a recent article in the Financial Times, David Fishwick, head of tactical asset allocation at M&G Investments, pointed out that the flexibility of derivatives makes fund management and asset allocation decisions more efficient, thereby helping M&G Investments to contribute an additional 50 basis points a year to the total performance of the Prudential Life Fund since 2000.
In conclusion, Eurex derivatives offer numerous applications for pension fund managers to efficiently invest in the fixed income and equity markets. Moreover, they provide various ways, either with futures or options, to protect the value of the portfolio holdings from a downward move in the market. In addition, alpha can be generated by using derivatives to leverage on the existing assets under management.
Table One: Using futures and options in pension fund management
Cash equitisation Reinvestment of coupon and dividend income and investment of new flows or funds generated via asset sales by purchasing equity index/bond futures.
Hedging portfolio value Sale of futures/buying of puts or collars to protect portfolio value.
tactical asset allocation Sale of equity index and simultaneous purchase of bond futures to assist in the reallocation of funds from equities to bonds (or vice versa).
duration adjustment Purchase/sale of equity index/bond futures to adjust portfolio beta/duration.
Sector overlay Purchase/sale of sector equity index futures to increase/decrease exposure to the sector within the equity portfolio.
Bond/stock picking Sale of bond/index futures against purchase of cash bonds/equity to isolate or negate market risk.
Portfolio yield enhancement 1. Sale of out-of-the-money (OTM) index/bond calls, anticipating limited market upside.
2. Sale of OTM index puts/bond puts, anticipating limited market downside.
3. Sale of OTM index/bond calls and puts, anticipating range bound market conditions.
Table Two: Using futures to facilitate a change in asset allocation
Situation A pension fund manager decides to switch €50m of his blue chip European equity portfolio into benchmark European government bonds. The equity holding has a beta of 1.15 to the Dow Jones EURO STOXX 50 index futures contract. The fund manager decides to sell these index futures and buys Euro-Bobl futures to facilitate the asset allocation switch. The cheapest bond to deliver for the Bobl contract, the 4.5% July 2009, has a duration of 4.19, very close to the current duration of 4.25 for the fund managers' benchmark European government bond portfolio.
Solution To calculate the number of Dow Jones EURO STOXX 50 index futures to sell:
(Value of equity holding/value of Dow Jones EURO STOXX 50 future) * portfolios beta = (€50m/ €26,440) * 1.15 = 2,174.7 ~ 2,175 contracts. (Value of index future = futures index * €10 = 2,644 *€10 = €26,440). Calculate the number of Euro-Bobl futures to buy: (Duration * investment * 0.0001/BPV (basis pointvalue) Bobl future = (4.25 * €50m * 0.0001/€48.76 = 435.8 ~ 436 contracts. (BPV Bobl future = BPV cheapest to deliver/price factor). Therefore the fund manager sells 2,175 Dow Jones EURO STOXX 50 contracts and simultaneously buys 436 Euro-Bobl futures to quickly switch a €50m holding in European equities to benchmark European government bonds.
Table Three: Using Euro-Bund futures to adjust portfolio duration
Situation A pension fund manager has a €50m government bond holding and decides to increase portfolio modified duration from 4.3 to 7.9 - the alternatives facing the fund manager are either to switch out of the current bond holdings to longer duration bonds or to overlay the current euro bond holdings with Euro-Bund futures contracts.
Solution 1. Calculate BPV of the current fixed income portfolio. Portfolio BPV = Portfolio modified duration * portfolio value * 0.0001 = 4.3 * €50m * 0.0001 = €21,500.
2. Calculate portfolio BPV with the higher duration target. Portfolio BPV = 7.9 * €50m * 0.0001 = €39,500.
3. Calculate the appropriate number of Euro-Bund futures contracts to reach the target portfolio duration. Futures = (target portfolio BPV - current portfolio BPV)/ BPV Bund future = (€39,500 - €21,500)/ €86.58 = 208.5 ~ 209 Euro-Bund futures. (BPV Euro-Bund future = BPV cheapest to deliver/price factor). The pension fund manager buys 209 Euro-Bund futures to increase portfolio duration from 4.3 to 7.9.
Table Four: Using Dow Jones EURO STOXX 50 futures to adjust portfolio beta
Situation A pension fund manager has a €50m portfolio of European blue chip equities that has a beta of 1.25 to the Dow Jones EURO STOXX 50 index futures contract and wants to increase the portfolio beta to 1.8. The manager decides to overlay Dow Jones EURO STOXX 50 index futures contracts to quickly increase the portfolio beta rather than incur the transaction costs of buying more cash equities.
Solution The number of Dow Jones EURO STOXX 50 contracts to buy to alter the beta of the €50m equity portfolio from 1.25 to 1.8 is determined by the following formula: (Value of portfolio/value of EURO STOXX future) * (target beta - current beta). Value of EURO STOXX future = futures index * €10 = 2,644 * €10 = €26,440. Therefore, the fund manager buys (€50m/€26,440) * (1.8 - 1.25) ~ 1,040 Dow Jones EURO STOXX 50 index futures contracts to increase portfolio beta from 1.25 to 1.8.
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