GLOBAL - The messy collapse of Lehman Brothers has led pension funds to look again at the use of derivatives in their portfolio, the results of the latest Global Pensions 100 Panel have shown.
Nonetheless, while counterparty risk is causing major headaches amidst the ongoing turmoil in the financial sector, it seems faith in derivatives themselves as an essential portfolio tool remains unchanged.
One panel member stated: "Derivatives are not the problem. Any instrument used without proper regard to its risk characteristics will lead to problems."
Another member suggested their fund's action on derivatives came as part of an overall portfolio reshuffle taking place due to current economic conditions: "Actions on derivatives are the result of an overall shift in our risk allocations and not a reaction to specific products."
Industry commentators have also been quick to defend derivatives.
Nick Horsfall, senior investment consultant at Watson Wyatt, stated recently: "While Lehman Brothers' bankruptcy and ongoing volatile markets have perpetuated the very challenging investment environment, those high governance funds that use interest rate and inflation swaps will have found that they have proved their worth in managing deficit risk.
"As such, we expect pension funds and their sponsors to continue to use various derivative instruments, albeit at a slower rate, because of a broad realisation that they can provide protection, enhanced performance and a better match for liabilities."
Eric Palley, head of Americas pensions team, Corporate Solutions, BNP Paribas, commented: "The results of the survey actually understate what is happening right now. Many pension plan sponsors, their advisers and asset managers are extremely concerned about risk from their derivative counterparties, more so than any liability related risk.
"They are not questioning the use and usefulness of derivatives ('what to buy?'), but how they have been managed and administered ('who to buy from?'). Have pension plans set appropriate collateral management requirements? Can they properly monitor operational and liquidity risks? Have they diversified counterparty risk? The most fundamental issue now is having the right counterparty in the first place."
Making a similar point, Michael Schlachter, managing director, Wilshire Consulting, added: "It is good to see that 90% of the respondents aren't closing the proverbial barn door after the cow has vacated the premises. The fact is that derivatives are like 12-inch chef's knives. In the right hands, they can be incredibly useful tools. In the wrong hands, they can cause disaster - especially a self-inflicted disaster.
"Clients need to understand the derivatives in their portfolios, but absolutely restricting their usage is a mistake. Bond and stock futures trade more liquidly than do their cash equivalents, and swaps and options can often be used to decrease risk. A blanket restriction can limit the opportunities for a talented manager to reduce risk and costs, but clients need to be sure said derivatives are being used for good and not for (leveraged) evil."
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