Pension funds, which are traditionally conservative investors, are reconsidering equity derivatives, as more volatile stock markets threaten their returns on cash equities.
In the middle of last year, the Austrian pension fund APK Pensionskasse increased its cash position and used equity index futures to short the market in anticipation of a correction.
In early June, APK started to short Euro STOXX 50 futures to hedge out the European portion of its equity portfolio and S&P 500 futures for the US portion. In doing so, the fund transformed part of its long equity portfolio into a portable alpha strategy and helped to reduce the fund’s long equity exposure by 25% to 30%, thereby protecting itself from the ensuing market downturn.
By the end of August, the hedge had paid off, the equity portion of APK’s fund having returned 7% above its benchmark, a combination of the MSCI Europe and the MSCI World Index, excluding Europe.
Other recent high-profile instances of pension funds using derivatives have included two in the UK. In December, it was reported that the £9.4bn ($18.4bn) British Steel Pension Fund had used equity options to defend itself against market falls. The fund implemented a collar strategy, buying FTSE 100 put options with a notional value of £1.3bn and call options worth £900m, thus capping how much the fund’s stocks can rise in return for limiting the amount they can fall.
In January, BT Pension Fund – the UK’s largest with almost £40bn in assets – put a hedging strategy in place that insured one-fifth of its equity exposure against stock market falls.
APK, British Steel and BT are still the exception rather than the rule but such successful strategic moves, in tandem with recent market turmoil, should serve as encouragement to many others.
Immense potential
Consultancy Watson Wyatt estimates that global pension assets totalled $24,932bn at the end of last year – in some countries pension fund assets even exceed gross domestic product. However, the extent to which pension funds use equity derivatives is a matter of some debate.
| Simon Yates, head of global equity derivatives at Credit Suisse, estimates that pension funds’ use of equity derivatives stands at about 5% of its potential, while Adrian Valenzuela, global head of investor sales for equity derivatives at JPMorgan, believes it is double that amount. Both, however – and perhaps with an eye on the aforementioned Watson Wyatt figure – agree that the market has immense possibilities for them. |
| Denis Frances, global head of flow sales at BNP Paribas, concurs. “There is a very significant amount of growth potential for equity derivatives in the pension fund sector,” he says. |
| Hassan Houari, head of equity derivatives structuring at Barclays Capital, points out that some very sophisticated funds are actively using the instruments already, but also says that the pensions industry as a whole needs to consider stepping up its derivatives usage.However, because the funds are not universally derivatives-savvy, he says that this will first require education. “It will be up to the investment banking industry to share and export its expertise to this market and to make sure that the products and solutions offered are suitably adapted, liquid, transparent and understandable,” he says. |
| Emmanuel Goudouneix, head of global solutions for financial institutions at Société Générale (SG), says that this has forced the Dutch funds to pay particular attention to VaR, “in some cases asking us to assess where the risk is and how we can help hedge it or provide diversification to push up the efficient frontier”. |
