Of the funds surveyed, 79% use derivatives frequently, predominantly for risk management, portfolio rebalancing and manager transitions.
Derivatives are a class of financial products that are based on an underlying asset, without actually being that asset; their value is derived from the value of the underlying asset. Derivatives themselves can be thought of as contracts between two parties that specify a time in the future when the parties will finalise a payment between themselves. A common version of a derivative is a future, where the current price of, for example, a stock is locked-in to be paid at a future date. This way, the seller can secure the current price for their shares against any future loss, while the buyer hopes to make a profit by buying the shares at a lower price than they will be worth in the future.
How super funds are using derivatives
|Incremental yield (yield enhancement)||42%||52%||3%||3%|
|Market timing, re-balancing (DAA)||39%||18%||27%||15%|
|Manager transition management||0%||48%||48%||3%|
|Physical security replacement – gain exposure||33%||36%||21%||9%|
|Source: Milliman 2017 Australian Derivative Study|
Funds using derivatives to manage risk
Super funds use derivatives for a variety of reasons, but the Milliman survey showed the most common reason was to manage risk, protecting their funds from any downturn they suffer from other investments. 55% of surveyed funds used derivatives for risk management all the time, while 52% used it sometimes or often. The other most common reasons to use derivatives were for fund manager transitions and rebalancing portfolios, with 51% and 42% doing so respectively.
However, funds very rarely used derivatives to leverage exposure – to invest more than the fund actually owns. 88% of funds responded they never use derivatives to leverage, while only 6% do so often. Tax minimisation is another rarity, with only 9% of funds doing so at all.
Of the funds that refuse to use derivatives, almost a third felt they could still meet their objectives without them, 18% thought they were more complex than they were worth and 9% felt their negative perception in the wake of the global financial crisis was too damaging.
Derivatives is not a dirty word
Derivatives have been something of a dirty word in finance since the global financial crisis when a type of derivative called a collateralised debt obligation was one of the major products implicated in the sub-prime mortgage crisis that ignited the GFC. Despite their reputation, the Australian super industry has a ‘mature and healthy approach to derivative usage,’ according to head of fund advisory services for Milliman, Michael Armitage.
Mr Armitage was critical of the low number of MySuper funds and choice/pension funds using derivatives for downside protection – using them to hedge a particular asset deemed at risk. According to Armitage, only 31% of MySuper funds and 37% of choice/pension products used any downside protection at all, despite the GFC ‘exposing the limitations of diversification as a risk management strategy.’ He claimed the use of derivatives could help offset the growing risks of fixed income’s lack of diversification as rates potentially rise.
You can see the survey’s findings here.
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