Tag Archives: Chris Sill

Boring derivatives

In public, and particularly in the news media, the word “derivatives” always seems to be spoken with ire or disgust. Stories involving derivatives are usually aimed at shaming greedy “Wall Street types” or describing the calamitous damage inflicted by an ill-conceived derivatives position. Wherever derivatives are mentioned there is likely a picture or graphic containing either handcuffs or a face-palming trader. Even Warren Buffett called derivatives “financial weapons of mass destruction.” But is there really cause to be terrified of derivatives as a whole? Part of the problem is that “derivatives” is a very large asset class, describing all assets whose values are derived from a notional amount and an observable event (e.g., default of a particular company) or underlying value (e.g., an interest rate or stock price). Thus “derivatives” have the potential to be very complicated. But because it is such a large asset class, maybe some derivatives are very simple. Maybe some derivatives are liquid and accurately priced. Maybe some derivatives are regulated. Maybe some derivatives allow for very cost-effective risk management. Exchange-traded equity index futures are that type of derivative. They are boring derivatives.

When investors execute equity index futures contracts they are agreeing to either buy (long) or sell (short) the value of the underlying index at contract expiration for the price as stipulated in the contract. For instance, if an investor were to take the long position in an S&P 500 futures contract, when the S&P 500 futures price was 1400, at contract expiration they would be required to pay:

(1400 – S&P 500 value at contract expiration) * contract multiple, where “contract multiple” is a standard contract term essentially defining the notional of the contract

Should the S&P 500 be higher (or lower) than 1400 at contract expiration, this value would be negative (or positive), indicating a negative (or positive) payment be made by the investor. Another way of saying this is that the investor would realize a gain (or loss). The reason for this is that the investor previously agreed to pay 1400 for something that is now worth more (or less) than 1400.

The potential gain or loss from a contract of this sort could grow quite large. It is because of this potentially large loss that margin is required to engage in futures trading. The amount of margin required is set by the futures exchange. As markets fluctuate and unrealized losses (or gains) become large, additional margin deposits may be required (or excess margin may be withdrawn). Open contracts can be, and in practice usually are, settled prior to expiration by entering into exactly offsetting positions, thereby realizing any previously unrealized gain or loss.

From a risk management point of view, the potential benefit of utilizing equity index futures contracts comes from the fact that large exposures can be acquired for minimal cash outlays. Margin requirements are roughly reflective of the exchange’s view of volatility and the investor’s open positions. In this way, an investor’s required margin is the amount roughly equal to that necessary to cover a large, unlikely, one-day loss on open contracts. For instance, in order to get an exposure the equivalent of $100,000 to the S&P 500, the required margin might be $10,000. By engaging in net short positions in equity index futures, investors can greatly reduce their broad market equity exposures without having to liquidate their equity holdings.

Equity index futures contracts are exchange-traded, meaning an exchange facilitates all trading. Margin is required of net long traders and net short traders. As markets move, gains accrue on one side, washing out losses on the other. The margin requirements protect the exchange and virtually guarantee each investor’s ability to settle their potential liability. As such, it’s very likely that equity index futures will remain boring derivatives. That’s exciting.

I can’t believe it’s not beta

Traditionally, hedge funds have sought to achieve outsized returns relative to the level of market risk in their portfolios while simultaneously maintaining a low correlation with the market at large. In other words, they seek high alpha and low beta. Proprietary investment strategies and relaxed reporting requirements have helped to make these goals possible, but also aiding the endeavor was a lack of appropriate investable benchmarks against which hedge funds might be measured. However, the emergence of hedge fund replication strategies (subscription required) might help institutional investors to more accurately assess the performance of hedge funds and correctly identify and quantify the components of their returns. Furthermore, hedge fund investors suspicious of the relative value of investing in single funds or funds-of-funds (“I can’t believe it’s not beta”) may now have a lower-cost avenue for accessing hedge fund beta.

Hedge fund replication is the general name for strategies attempting to replicate, or beat, the returns of hedge fund indices using assets that are potentially more liquid and transparent. For instance, a replication strategy might attempt to achieve returns similar to a particular hedge fund index while only investing in equities. Successful strategies would achieve returns very similar to their target indices, creating lower-cost, investable hedge fund beta.

Potential investors should consider carefully before allocating assets to hedge fund replication strategies as there are potential downfalls. First, the replication strategy may or may not perform as expected, meaning that an investor may or may not be able to access hedge fund beta. Second, although fees associated with replication strategies are generally lower than direct investment in hedge funds or hedge funds-of-funds, they are still rather high, typically comprising either a 1% to 2% management fee or a 15% performance fee, according to a recent Pension and Investments article. And finally, investors should consider their goals in making any asset allocation. Hedge funds, or hedge fund replication strategies, may provide diversification, but at a significant cost. Further, if risk management is the end goal, and diversification simply a means for achieving that goal, it is important to remember that diversification relies on correlation and, as correlations vary over time, diversification alone may not prove an effective risk management tool. Focused risk management strategies may be more effective in meeting those goals at a much lower overall cost.

The need for (responsible) growth

Liability-driven investment (LDI) strategies have been around for some time now. The main idea behind LDI strategies is that pensions should invest in long-term fixed-income securities in order to match their long-term liabilities. The theory is certainly sound; if a pension is able to accurately match all sensitivities to the yield curve of both assets and liabilities then its future income statements would not be subject to future interest rate moves. But a reduction in volatility of future cash requirements does not necessarily mean a reduction in future cash requirements.

For instance, underfunded plans may simply be locking in large future cash requirements if they were to move to an LDI strategy. This would be caused by the need to make up their funding deficit through future contributions. Further, even some well-funded plans may lock in large future contributions, which is due to the potential discrepancy between the assumed earned rate on assets in the actuarial valuation (current funded status) and the actual rates available in the market currently. Locking in future contributions may be feasible, or even preferable, to some well-funded pension plans. But for others the need for growth remains.

Growth assets such as equities are necessarily accompanied by an increase in volatility. Generally speaking, asset allocation strategies comprising equities have focused on notions of the long-term expected returns and volatilities of these assets, along with their correlations with each other and other portfolio assets. But such methods have ignored short-term fluctuations in these expected values. For instance, at the beginning of the financial crisis in September 2008, short-term realized equity volatilities were around three times their historical average levels. Accordingly, portfolio volatilities were much higher than targeted and, as most of the volatility was on the downside, much pain was felt.

Therefore, the need for asset risk management, as part of a comprehensive risk management process, is greatest in those plans requiring investment in growth assets. As such, this has become a hot topic of discussion among investment advisors, risk professionals, fund managers, and academics.

The need for portfolio growth should not be viewed as a license for unmitigated risk-taking. Equity risk management strategies involving the purchase of put options have been around for some time, but they are very expensive and rigid in the long term and require precise market timing in the short term. Another fund strategy, risk parity, seeks to create a fund with equal risk contributions from different asset classes. Given the lower volatility of bonds, however, this necessarily means large bond allocations, which may not be desirable given the current interest rate environment.  Ideally, a pension plan would benefit from a futures overlay strategy that combines formula-driven volatility management plus capital protection to help mitigate equity risk. The Milliman Managed Risk Strategy offers exactly that, and when combined with an effective LDI strategy, the pension portfolio becomes well positioned for (responsible) growth!

Revolutionary risk management for pension plans

Investment consultants and plan sponsors find themselves in a tough spot these days. Many plans are underfunded, which is due to the financial crisis and rock bottom interest rates. In order to avoid costly contributions, outsized returns are needed to shore up their funded statuses. However, outsized returns may mean taking on outsized risk. And, if the first financial crisis left pension portfolios crippled, a second one could prove catastrophic.

Who has found a solution? Life insurance annuity providers adopted hedging as an industry standard practice by 2006. Such programs proved 93% effective during September and October of 2008, saving the industry an estimated $40 billion in reserves. Variable annuities, similar to pension plans, promise a guaranteed lifetime payout stream backed with equities. Therefore, the compelling success of these programs for annuity providers can be applied to pension plans as well.

The Milliman Managed Risk Strategy is a multi-faceted futures overlay strategy for pension portfolios that aims to capture, on average, 80% of the upside potential of equities with 25% of the downside exposure.

Using equity futures contracts, some of the most liquid and simple financial assets available, MPS adjusts market exposures in order to provide a risk and return profile that is superior to traditional asset allocation models. Through the combination of the capital protection strategy and volatility management, the MPS adjusts market exposures to maintain a nearly constant risk profile while simultaneously providing a cushion of protection against market downturns.

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