EUROPE - Equity derivatives and credit swaps are increasingly capturing interest from pension funds, but the market could be distorted if all pension funds were to engage such instruments, according to Schroders.
Undoubtedly derivatives can be used to manage a portfolio more robustly, minimising the downside risk for the price of capping the potential return. Schroders executive director, David McLaughlin, emphasised: “This is not a fad.”
On the equities side, structuring tools offer protection from downside risk, which enables a pension fund to continue to participate in the expected long term growth. Selling a call on the upside and buying a put on the down insures against a falling stock or index.
But there is a small risk that should a great number of pension funds invest in this way, the market could become skewed to such an extent that put options would become overly expensive, and call options on the sell side would become very cheap. This would mean that the cost of insuring against the downside risk would far outweigh the gain.
However, with a distinct minority of pension funds at the investment stage, “we are still a long way off from this point,” said McLaughlin. There are also other ways of replicating options to achieve a similar effect, such as selling futures.
The use of structured investments is one way of allowing pension funds to link portfolio performance more exactly with particular liabilities, which is a trend unlikely to go out of fashion.
The knee-jerk response to closing the funding gap is to shift from equities to bonds, but this is unfeasible for two reasons, suggested McLaughlin.
“The timing seems wrong, and for most pension funds it’s too expensive.”
Thus, in order to meet their liabilities, pension funds are being pushed to look at other ways to achieve higher returns, whether this involves enhancing bond returns or taking greater risks in equity markets.
Credit default swaps overlaid on a conventional bond portfolio can increase the yield by leveraging high quality credit exposure, without having to move down the credit scale, said McLaughlin.
Rob Marsden, European principal at Mercer, commented: “As the bond market evolves, these tools are likely to evolve with it and I think they are unlikely to disappear, because there is going to remain a strong interest in bonds, regardless of whether equity market valuations stabilise or not.
“The tools have evolved as the structure of the bond market has changed, and credit has become an important component of the global bond market. Just like interest rate derivatives have evolved, so too have credit derivative instruments and they are likely to grow in importance as a management tool for fixed income portfolios.”
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