Into the fold 

Darren Rosario helps manage about 30 per cent of Equipsuper’s $4.4 billion across four asset classes: core Australian equities, fixed interest, infrastructure and cash. As a senior portfolio manager in the fund’s internal investment team, he trades derivatives with many counterparties for the “very simple” tasks of equitising cash flows, he says. “We are using the most simple of products and have avoided the more complicated structures, because the biggest issue is counterparty risk,” Rosario says.

The team explains its use of derivatives to the Equipsuper board through investment strategy manuals and policy statements. Under new prudential regulations, they can describe their use of derivatives in broad risk management plans, rather than in a discrete document.

In December 2010, the Australian Prudential Regulation Authority (APRA) advised funds that disclosures made in a Derivative Risk Statement (DRS), which exclusively covered funds’ use of derivatives, could now be made through a comprehensive Risk Management Plan. APRA realised that completing a DRS is a “mechanical, box-ticking exercise”, says Anne MacNamara, partner at law firm Henry Davis York.

Isolating derivatives from other investment risks indicated that the instruments should be used under specific circumstances and with more caution and separate recordkeeping. “Now there is a much more realistic recognition that in a diversified portfolio these instruments have a place.

But you have to assess the risks like you would for any other investment,” MacNamara says. Ultimately, the instruments should be accurately priced and transacted by experienced traders who abide by risk management policies, she says. APRA focused on risk management in a discussion paper about prudential standards in superannuation, circulated on September 28.

Gillespie says this will force medium- and large-sized funds to develop more comprehensive risk management systems in coming years. “I think they’re going to look much more like existing deposit-taking institutions and insurance companies,” he says, in which internal risk management specialists report “straight to the board” instead of executives.

Longevity hedge

The financial crisis showed how market crashes can devastate the savings of people approaching or currently in retirement. Because many older people who lost money cannot return to work and rebuild their savings, they must draw on their depleted balances and, in the process, lock in losses.

This means a priority for many funds is to provide retirement investment products that are designed to extend members’ income streams after they retire. Davies says retirees are the “real angry ones” among the audience at member briefings hosted by corporate funds.

The equity investments supporting their allocated pensions have been eroded, he says, causing a corresponding fall in income. But many funds will continue to expose retirees to market risk in order to sustain retirement incomes. Rosario says funds need to convince pensioners that equities – particularly high-dividend yielding stocks – are beneficial in retirement, and explain how derivatives strategies can help protect these investments.