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Introduction The use of derivatives is becoming more and more widespread in fund management around Europe. The advocates of derivatives point out their huge liquidity, their low transaction costs and the reduced interference in the stockpicking process by using derivatives for tactical asset allocation. In contrast, the opponents of derivatives point out that the scandals which have rocked the investment management industry in the UK, Europe and the USA in recent years have often been as a result of derivative usage. Certainly, it is clear that the control of these instruments is vital to the ongoing health of investment management companies. One of the more important aspects of control is the correct reporting of derivatives and their potential impact on investment portfolios. The main published work on this topic in the UK, setting out a variety of recommendations, was issued as a joint venture between LIFFE and the actuarial consultancy company, Mercer Fraser, in January 1992 and was entitled "The Reporting and Performance Measurement of Financial Futures and Options in Investment Portfolios". It is a report that is heavily biased towards equity derivatives, but is adaptable by derivative specialists for fixed income and currency markets. In this article, Trevor Robinson discusses how little impact this report appears to have had on the reporting of derivatives and what errors are still being made by European pension funds - or their managers - in this area. Reporting of Futures The above-mentioned report makes recommendations on the appropriate way to report transactions in futures. The most important recommendation is to report futures contracts in terms of their underlying exposure, not the profits achieved and certainly not the daily profit and loss ("margin") flows. Once futures contracts are used in a portfolio it is no longer sufficient to focus on the "market value" of investments, which has been used traditionally. This is because the "market value" of futures contracts is usually nil. The margin process associated with all futures contracts means that profits and losses are paid to / by the investor daily and therefore create that nil market value . However, the lack of a market value does not mean that the existence of the futures position will not have an impact upon the portfolio if the market moves - for example, a long position in futures contracts will require a significant outflow of cash in terms of margin call if the underlying market were to fall, and the overall portfolio would be reduced in value proportionately. Having accepted the need to focus on underlying exposure, the report makes the sensible recommendation that an equivalent amount should be deducted from the cash holdings. Indeed, the regulations which govern the use of futures contracts in unit trust and insurance funds in the UK describe this as "cover" for the futures transactions. If this is done and reported correctly, it prevents the portfolio becoming geared to the market. Reporting of options The above-mentioned report also makes recommendations on the appropriate way to report transactions in options. It states that options contracts should be reported in terms of value at market price (current option premium in the market). This is an easy principle to understand and also to put into practice for most fund management companies.
If external independent advice is required, please e-mail us for more information by clicking here. Recent Experience Based upon work commissioned by pension fund and insurance company clients in the last few years, experience shows that a number of reporting systems commit the same errors. The most common error in valuing a portfolio containing futures contracts is to calculate the profit on the (long) futures contract based upon the difference between the current market price and the (lower) original purchase price. The reason that this approach is incorrect is that those profits have already been paid to the fund in cash via the margin system. Effectively, the profits are being counted twice. The second most common error is to exclude from the valuation the initial margin paid to the clearing broker. As this initial margin is returnable upon closure of the futures contract it should be treated in the valuation as if it were a temporary cash deposit with the broker. In addition, as mentioned in an earlier footnote, futures contracts can have a market value within the trading day, or more strictly between the times of margin receipts or payments. For funds that are valued at midday, this value is often omitted from the total portfolio value. The most common error in reporting futures contracts in a portfolio is to ignore them! The profit or loss on the futures position may be correctly reported, but the fact that it may have a significant subsequent impact upon the portfolio is often quietly forgotten. In addition to the external reports to clients, internal management reports often do not ensure that: Even when correct reporting is being used, it is easy to get the impression that no-one providing the report actually reads it before it goes to the external client. If the report generation system has been structured correctly, and it does show a geared position from the use of derivatives, it might be sensible to mention that fact in the covering letter or written report to the client, and say why it has arisen, or what has been done to correct the position. Special considerations for bond portfolios Bond fund managers will sometimes use a combination of long bonds and cash to achieve a desired duration target, rather than switching the entire portfolio into medium term instruments. If the portfolio is being structured in this manner, but then subsequently futures contracts are purchased, it is quite sensible to treat that cash as "cover" for the futures contracts, but only up to the point where the fund is not geared. There is a real danger that, in order to retain her flexibility in achieving a changing duration target at the same time as being fully invested, the fund manager will find that the combination of cash and futures contracts will result in the fund becoming geared. Special considerations on currency exposure The ready availability of currency forwards and futures contracts means that the currency exposure of an investment portfolio can be markedly different to its bond exposure, therefore there is a need for a clear benchmark in this area too. A direct investment in Japanese equities gives an exposure to the Japanese stock market and also an identical currency exposure in terms of the yen. A fund manager who does not wish to have the yen exposure can make the decision to hedge back into sterling, a process that would usually take place through the currency forwards market. However, a fund manager who purchases a futures contract on a Japanese stock market index gets no exposure to the yen and therefore should not be considering an additional currency hedge. Combined reporting in a portfolio In "olden times", before derivative usage became popular, it was easy for a UK client to predict what would happen to his portfolio if he knew that his manager was going to be fully invested in UK equities, for example. He knew that if the index rose by 10% over the subsequent six months, then his portfolio would rise by close to 10%, any difference being attributable to the stockpicking skills of the manager. Nowadays, derivatives can change the characteristics of an investment portfolio to such a degree that it is important for the manager to provide his client with a new "rule of thumb". The best way to do this is by reporting on the impact on the total portfolio, including derivatives, of a 10% rise or fall in the market over the next six months. Certain assumptions have to be made in this process, but they are not extreme. This eminently sensible approach is rarely seen in client reports at the moment.
If external independent advice is required, please e-mail us for more information by clicking here. Conclusion Trustees of pension funds and Boards of insurance companies and unit trust managers now have greater responsibilities relating to investment activities than in the past, yet few of them have any knowledge of an esoteric area such as derivatives. The first step in changing that situation is by providing training. Interestingly, experience shows that employees in settlement departments need just the same amount of training, in order to enable them to understand their tasks better. Certainly, it is vital for fund managers, compliance officers and pension fund trustees to have an understanding of derivatives and how they can affect the investment performance of the funds under management. If the equity market fell by 20% one month, the Board would expect the equity holdings to fall by a similar amount; it should have a similar understanding of the broad thrust of its derivatives strategy - e.g. "if the market fell by 20% in the next month, the portfolio would fall by only 15%, derivatives protecting the portfolio to that degree. But if markets were to rise..." An investment manager has to decide on the strategy that is behind her desire to use derivatives, then report it reflecting performance against that strategy. Only then can the Board make a sensible decision on whether derivatives are adding value to portfolios or not. Education of relevant members of staff from the top of an organisation to the bottom is a vital part of the control and compliance process. The more people watching for potential regulatory breaches or poor reporting, the more likely they are to be spotted before they become a major problem. Such education should include not only the theory of the use of derivatives, but also the practical side of how to interpret the reports being generated. These reports should be sufficient for the fund manager to monitor her positions, for the Chief Investment Officer to monitor the fund management activity, for the Compliance department to check whether the investment guidelines are being obeyed and for the Board Members or Trustees to be able to fulfill their statutory obligations of control. Trevor Robinson specialises in giving advice to institutional investors on how they should use derivatives in fund management in an appropriate manner. Before October 1994 he was Head of Derivatives and a Director of both Fidelity Investment Services Ltd. and Fidelity Pensions Management Ltd. |