In the wake of a financial crisis that levelled many retirees’ savings and taught the investment industry a severe lesson about the perils of financial engineering, an honest discussion about the risks and merits of derivatives is warranted. Investment Magazine and Tibra Investment Management recently convened a roundtable in which superannuation, investment, tax and legal experts looked beyond the scapegoating of structured finance and asked how derivatives can be used in fund portfolios. SIMON MUMME reports.
Metaphors and similes are useful in sales pitches. Managers of emerging market equity or bond funds usually say that Brazil, Russia, India and China are “the new growth engines of the global economy”. Their hedge fund counterparts tell investors that the absolute return strategies deliver “equity-like returns with bond-like risk”.
In 2002, investment legend Warren Buffett famously said that the burgeoning trade in complex derivatives made them “financial weapons of mass destruction” that not only imperilled the circles of investment banks trading them but also threatened the global economy at large.
Derivatives based on ill-fated US mortgages gained notoriety as the supposed catalyst of the 2008 financial crisis that plunged the world into recession. They did not cause the crisis, but as Buffett noted, enabled much of the excessive risk-taking at its roots. As banks lost gambles on US mortgagebacked collateralised debt obligations (CDOs) and other securities, derivatives became shorthand for financial “mass destruction”.
Investors soon knew about the potentially severe counterparty, leverage and liquidity risks of derivatives. Superannuation trustees have been scared stiff of the complex securities ever since. This makes work challenging for Chris Briant, CEO of Tibra Investment Management (Tibra), a business spawned from proprietary trading firm Tibra Capital.
This year Tibra launched its first investment product, an Australian equities strategy that, naturally, uses pricing anomalies among equity derivatives to improve returns net of tax. When Briant explains this strategy to prospective clients it soon becomes clear that derivatives, deservedly or not, still have an ugly name.
“One of the first things that CIOs say is, ‘Oh, it contains derivatives and our trustees are terrified of them given what happened during the global financial crisis’,” Briant says. Is their terror justified? Negative returns from equities and unlisted assets, not derivatives, caused the poor performance of super funds during the financial crisis.
For example, the -25 per cent return of the $6 billion MTAA Super balanced option in the 2008-09 financial year was largely attributable to the fall in value of its large unlisted assets portfolio. During this period, the fund lost about $500 million after failing to pay the escalating cost of its currency hedge on international assets as the Australian dollar fell from US$0.96 to US$0.62 in eight weeks.
The currency forward contracts performed as expected: it was MTAA Super’s lack of liquidity that caused the hedging failure. However, in the years leading into the financial crisis, 72 Australian councils, churches and charities were swayed by promises of “equity-like returns with bond-like risk” and invested in CDOs sold by Grange Securities, the domestic arm of the collapsed Lehman Brothers.
They are suing the company – which earned $60 million by selling 51 CDOs between 2003 and 2007 – for $250 million in lost investments. Super trustees’ fears of derivatives are, understandably, not baseless.