Likewise, if the equity market goes sideways over a five-year period an investor paying for any form of equity option will have done worse than the market.

One can take the philosophical stance that paying for such insurance gives investors the confidence to maintain a higher exposure to equities than would otherwise be the case, but it has become much easier to model insurance cover. In this way, the amount of downside an investor wishes to avoid and the amount of upside it is prepared to give away can be tailored to match its own forecasts for the market, the rate of return it requires, but also to match their budget. 

Ahmad believes this process puts pension trustees in a greater position of power and saves time on understanding the language and practice of derivatives traders. “Rather than trying to understand the delta and the vega of your option, you need to know how to govern the structure and the investment manager,” he says.

Forced unwinding

One common way of paying too much for derivatives is if they are unwound before the contract ends. Many of the commentators for this article spoke of the punitive penalties imposed by banks in this regard. Some funds have even had contracts unwound when they had wanted them to continue. 

Philip Bennett, a partner at law firm Slaughter and May, notes that there are little observed clauses that allow counterparty banks to close out a derivatives deal. These are being employed opportunistically by banks, he says, that are facing increasing pressure from regulators to cut the levels of risk they are taking.

Bennett has seen this happen for clients that are in a pooled arrangement with other funds for interest rate and inflation swaps. Where one pension fund defaults on a margin call to the counterparty bank, the bank has the right to close off the whole arrangement that includes all other funds. While this is costly and no doubt frustrating Bennett describes not having greater protection from such get-out clauses as an error on the part of the funds involved.

“There are pension funds out there with agreements of this type that are blissfully unaware of the issue,” he says. “If you are looking at a stressed bank, all legal rights get exercised that you would ordinarily not commercially exercise.” 

Generally, the bigger the fund the more it is aware of the need to stress-test for counterparty risk, says Bennett. “Not all of the risks in extreme stress circumstances are sufficiently articulated.”

It is illuminating then to see the lengths the largest funds go to monitor their derivative use.

CalPERS’s stated list of control procedures covers: accounting and performance measurement; compliance controls; the monitoring of market risk exposure, liquidity needs and counterparty risk limits; and the evaluation of operations to ensure use of proper systems, controls, staffing and staff qualifications.

NZ Super sets maximum exposures to counterparties based on credit ratings. It also sets out the responsibilities of key individuals in relation to derivatives, a list that covers the roles played by its head of operations, legal team, chair of investment committee, head of portfolios and CIO.

APRA, the main regulator of superannuation funds in Australia, emphasises that trustees must set an objective for using derivatives. This may sound simplistic, but the importance of such objectives were tested in the large volatility seen in global markets in January 2016.

Most Australian super funds typically have allocations to equities of around 60-70% and for many this was an opportunity to cash in options. Media Super was one that did, making a profit on its overall hedging strategy if not its overall portfolio.

At times like these, some super funds find that there were conflicting views internally on whether they should cash in on the price of their options and make a profit, or hold on to them for an even worse scenario.

QIC, one of the key providers of options to the Australian market, says buyers must understand the full consequences of selling options. Neil Williams, investment director at QIC, says that whenever a fund introduces or withdraws an option, it is effectively changing its asset allocation by either raising or lowering its exposure to equities. This, he believes, should be factored into any decision.

“If you think you’ve hit a level of the market where it no longer makes sense, or you want to realise the money that you’ve made on the option, and you sell the option you are effectively raising your equity exposure,” he says.

At such times, it can help to have an experienced practitioner in the organisation. Since 2008 many large funds have taken in ex-investment bank employees who have a deep understanding of how derivatives work. Notably, Ron Mock, chief executive of Ontario Teachers’ Pension Plan, previously directed sales and trading staff in derivative products.

Collateral concern

Another challenge for investors is not focusing on the risks of managing collateral. This has become a serious concern for interest and inflation rate swaps as there is widespread belief that interest rates are now on an upward trend, increasing the call by banks for more contingent assets from investors.

If pension funds lack sufficient cash or gilts to post as collateral the risk is they will have to sell return-seeking assets to plug the gap.

Patrick Cunningham, partner and head of client management team at Cardano, advises funds to always stress-test the amount of collateral they have for this reason. This is a problem that has grown acute as banks are demanding a higher proportion of collateral for derivatives than they have in the past due to the higher capital ratios their businesses must hold now. Ten years ago, banks would demand collateral of 10%, but figures of 35-40% have become more normal.

Another issue resulting from record low interest rates is that with gilts now cheaper than swaps many pension funds are stopping the use of interest rate swaps and moving to gilt derivatives such as gilt repos or gilt total return swaps.

“The benefits of gilt derivatives versus swaps is you get a higher yield, but the downside is that you need to roll them periodically and the financing cost of doing so varies over time,” says Cunningham. “With a swap you knew what you were getting for 30 years – you did not need to roll it and the costs were embedded it.”

The increased costs come from rolling contracts up to several times a year. At each point market volatility might mean a higher cost than expected or an inability to strike a deal. 

David Wrigley, partner at LCP, says banks are now generally charging more for unwinding positions, particularly for special or non-standard contracts. This could impact any fund looking to unwind a long-term liability hedge if it finds another way to hedge, if it wants to pass its liabilities to an insurer or if large numbers of members transfer out. 

“If terms are non-standard then exit costs can be high as a bank would need to either find another party to take on those non-standard terms, take on the risk themselves or unwind hedges the bank may have in place,” says Wrigley.