But most super funds already use derivatives to hedge currency exposures and to “equitise” cash flows, which involves maintaining equity exposures until cash is found to fill investment positions, says Tom Gillespie, director of risk advisory at Russell Investments. Most fixed interest managers trade bond options, swaps and “swaptions”, he says, and some Australian equities managers run “buy-write” strategies.
This involves selling call options on underlying positions to receive income from option premiums to “build returns” in volatile markets, Gillespie says. But trustees are still reluctant to explore further uses of derivatives. “Most managers pitch wanting to talk about delta, gamma, vega and volatility,” he says, referring to jargon used to describe the pricing dynamics of derivatives. “But what is important to a trustee and a member is how much additional return they make and when they underperform the market.”
Managers should instead focus on the outcomes of their strategies, rather than processes, in their discussions with trustees. They should emphasise “two simple concepts: return and risk”, Gillespie says. Briant believes that derivatives can help manage investment risk for retirees as well as extract gains from tax management, and he uses a simile to convey his view of the controversial securities.
Briant, who is also a weekend lifeguard at Queenscliff on Sydney’s northern beaches, likens derivatives to defibrillators, the machines used to correct the irregular contractions of a heart attack. He says both are dangerous if used without risk controls.
But these risks can be tamed: new automated external defibrillators can be used to save lives without much first-aid training, and the risks of derivatives can be mitigated so they have broader roles in superannuation investment strategies. He’s got a lot of work to do.
Many trustees, who still link derivatives with excessive leverage, do not understand how the instruments can be used while mitigating risk, says Keith Davies, director and investment consultant at PricewaterhouseCoopers. “Leverage was the big issue of the crisis and probably will be for quite a while. So there is an automatically negative sentiment towards derivatives,” Davies says.
For super funds to expand their use of derivatives, trustees must be convinced why they should be used and how managers will control their risks, he says. Moreover, they must clearly understand these aspects in order to justify the use of derivatives to risk-averse members. Super funds have already failed to clearly articulate investment strategies to members, Davies says, and this task will become more difficult if derivatives play a major role. He says managers using derivatives will need to clearly show how they use the instruments.
“We’ve been among those that have been a bit anti of it all,” he says. “We’re still living with the financial crisis. So trustees are pretty uncomfortable about going into something they can’t understand.” Their views can change. Buffett learned how to profit by using the instruments. His investment firm, Berkshire Hathaway, earned US$222 million from derivatives in the fourth quarter of 2010.
Speaking to the Financial Crisis Inquiry Commission, Buffett said: “I don’t think they’re evil per se…there’s nothing wrong with having a futures contract or something of the sort. But they do let people engage in massive mischief.” At the time, Berkshire Hathaway held 250 derivatives contracts, according to The New York Times DealBook. Buffett had knowledge of “every contract”, he said. This would be almost impossible for an investment bank CEO whose traders were involved in tens of thousands of transactions.