By Gianluca Minieri, Global Head of Trading, Pioneer Investments
Many changes have occurred over the last ten years in the way that investment firms manage their strategies. Certainly at Pioneer Investments, we have seen a significant increase in the volumes of derivatives over the last few years. Ten years ago, asset managers like Pioneer (long only asset managers, insurance companies, pension funds) were all very traditional investors. They mostly managed plain vanilla strategies investing almost entirely in cash instruments, so mainly bonds and equities. In terms of investment, there was less pressure to perform given the market back then, so more focus on investment ideas and opportunities to exploit. The last ten years have been very challenging for institutional investors due to a combination of factors:
• the ultra-low interest rate environment,
• low volatility,
• negative rates in some cases and
• significant regulatory change.
In this environment, asset managers have had to significantly expand their product offerings due to competition and the increasing challenge of finding investment opportunities. The resulting trend that the asset management industry in general has taken, has been to increase the sophistication of investment strategies in an effort to improve performance, find new investment opportunities and beat the competition. The resulting trading strategies have consequently become more complex and more sophisticated. Often these strategies now cut across different asset classes, different instruments and different currencies. Directional strategies are combined with hedging activities, so derivatives are combined with cash instruments. Fixed income instruments are combined with equities across the same order, so the sophistication of our investment strategies has increased.
Increased use of derivatives
This type of environment has been the primary catalyst that has led to a significant increase in the use of derivatives in the financial industry in general. One very practical example is the increased demand from our clients for Absolute Return strategies; meaning strategies that can or have the potential to generate returns in ‘all-weather’ conditions. These strategies are, by definition, derivatives intensive, because they need to employ a wide range of different instruments, both cash and derivatives, and that are both listed and over-the-counter (OTC).
At Pioneer we have seen an increase in volumes of over 80% over the last year (yoy), with 120% over the last two years. Also, 90% of our business was traditionally on the spot-FX market, but today a significant portion of our business is made using FX-forwards. Over the last two years we have seen a 150% increase in terms of FX volumes. As a head of trading, I have had to consider if there is any way we might trade more efficiently to minimise or reduce our risk and cost. Our investment processes, in line with the rest of the industry, reflects that derivatives can have a multitude of uses.
Today’s derivative strategies
At Pioneer, we use derivatives for hedging, but also for yield enhancement. One of the typical uses for derivatives is to create overlay strategies. These strategies can provide exposure to specific risks on top of the core investment strategy for yield enhancement purposes. We also exploit derivatives to provide protection, with derivatives delivering a tailored exposure to a specific risk in a much more effective way than using an underlying instrument. Examples might include: covering a specific bucket on the interest rate curve, coverage for a specific duration, or to cover a specific sub-sector equity exposure. These are all situations where you can actually tailor your coverage by using derivatives, which wouldn’t be achievable using a cash instrument.
Another use of derivatives are the portable alpha overlays, where you use a derivative to exceed performance of a given market or a given exposure, through an investment in another unrelated asset class.
Derivatives managing risk
We see derivatives as a very valuable tool to optimise the way we manage our investment strategies because only derivatives can actually allow you to hedge the unwanted risk. Through the use of derivatives, the portfolio manager can exactly manage the risks that he wants to manage. Any unwanted risk, any risk that he doesn’t feel like managing, or that he doesn’t feel like sustaining, he can actually hedge very efficiently using a derivative instrument. Very rarely do we use them to speculate on the movement on the underlying asset. Derivatives are a set of precision tools that are available to the industry as a whole.
If you consider the way that the market has changed since the introduction of some regulatory measures, like MiFID 1 for example, you have seen the fragmentation of liquidity, the reduction of liquidity and so on. The reality is that markets have become more complicated. Policy makers have made it more difficult for investment banks to play the role that they used to play in financial markets. There are fewer capital providers and fewer market-makers, resulting in there being fewer firms that are ready to take risk on their book. Clearly, in financial markets you can never eliminate risk: a risk never disappears, it is only transferred on to someone else. Now, the asset management company has to take on that risk. A lot of risk has been transferred and now sits with us to manage. In the primary market, before a new issuance was raised, the underwriter took on the majority of risk. Today, the new issue (the new bond or stock) only takes place after it has been pre-sold to clients, with the asset manager taking on the risk.
As a result, we need to be more active in the way that we manage our investment strategies. Derivatives offer this type of possibility because you can buy or sell them with a small up-front cost. Sometimes they are more liquid than the underlying asset. If you want to hedge a specific risk for a short period of time, you just take a derivative exposure and then you unwind it when you don’t need it anymore. It is much more efficient. Derivatives often offer a better level of liquidity.
The consequences of implementing these derivative strategies
Going back a few years, the term ‘derivatives’ had negative connotations for many investors and regulators, mainly because they were widely misunderstood tools. This has changed. There also used to be a perception that the only way you could improve the management of your derivatives was to hire specialist, skilled people. Certainly we still need to have staff skilled in managing derivatives but the key to improvement is in the education and training of staff across the organisation – from the trader, to top management of the company, to people that manage the back office. Derivatives are very demanding, not only from an operational perspective, but also from an investment perspective; they carry more risk.
Derivatives create leverage, which means that when you take a position in derivatives you are taking a position that is bigger than your funded position. Leverage can amplify your returns, but it can also amplify losses. A small movement in the underlying assets can actually cause a large price difference in the value of the derivatives. It’s important for firms not only to have skilled staff that can trade them, but also to improve the knowledge and education across the whole company on how to manage a derivative through its lifecycle – from the time you trade the derivative, to the time that the derivative is in the NAV of the fund. This is the secret to success.
Proper infrastructure is essential: your order management system (OMS) and execution management system (EMS) must ensure that the order on a derivative is actually managed through the entire system. It is absolutely key that every single step of the cycle of the trade is done within the system. Processes must be formalised so everyone knows what to do and when. Systems must be capable of managing all the more demanding phases in the post-trade environment. For example, the complexity that extends from managing corporate actions, the contractual agreement, pricing and collateral management. Derivatives are complicated, and therefore demanding from an operational and administrative perspective, so systems, infrastructure, and tight processes are absolutely key.
In addition, the regulatory environments, (for example Dodd-Frank in US and EMIR in Europe) set a very high standard for banks and asset management firms in relation to the minimum requirements to trade derivatives. Dodd-Frank stipulates a need to have a swap execution facility, and EMIR a need to centrally clear OTC trades. These requirements need infrastructure and investment in people, systems, automation and so on.
Last but not least, are post-trade controls: all the monitoring processes that need to be present in order to manage the process correctly. It is essential to understand your risks through proper risk analysis, scenario analysis, sensitivity analysis: all the instruments that are used by the portfolio manager to understand what happens in case of a tail risk event. There are a lot of risks that might be sitting in your portfolio that seem manageable in a normal situation, but in the event of a tail risk you need the correct instruments to actually simulate what can happen. Sadly, we all know that in financial markets, a tail risk event has not been a rare occurrence over the last few years.
Buyside use of derivatives – Here to stay
Derivatives are a vital tool for the asset management industry, as they allow us to improve and enhance our investment process. If derivatives were not allowed for example, the number of transactions that we do quickly and economically using derivatives today, would have to be done using cash systems. We would sustain much larger transaction and operational costs, which eventually would be transferred to the clients. They would therefore see a deterioration in the cost of trading and consequentially, overall performance.
From a risk management perspective, not allowing derivatives (or creating a regulatory environment where the use of derivatives is not incentivised) would lead to a sub-optimal risk-return profile. This would be a cost to the final investors because derivative instruments allow us to specifically tailor the risk we want to hedge, for the time we want to hedge the risk, in a quick and efficient way.
Buyside use of derivatives is going to stay. The electronification of financial markets is happening not only on the equities and fixed income markets but also on the derivatives side. In the future, there is going to be a lot more automation in the way you trade derivatives which will help facilitate the operational complexity that usually results from the use of derivatives.
In Europe, more than 50% of asset management companies use derivatives compared to approximately 30% in US. Traditional firms in the past were less keen on this instrument, but now they trade derivatives and have the proper infrastructure to enable this.
There is of course associated cost. When you improve your volume by 100% you need to understand that derivatives are not free. While users don’t pay fees to trade them, the cost is embedded into their present value. So a cost-benefit analysis is needed when a portfolio manager wants to set up a position in derivatives. As a trading desk, we act as an adviser to the portfolio managers, sitting together with them, to ensure proper understanding of the best way to implement the strategy. We need to keep an eye on how much of the cost, in addition to trading, is involved downstream, including how many people are involved in processing that trade. The cost of trading derivatives means the cost of the entire infrastructure, including the organisational structure that you need to have in place to be able to trade. Cost will improve as we move to standardisation of derivatives, even on the OTC market. Currently, derivative trading is a bilateral contractual agreement between two parties, completely customised, and written on paper. Each one is different from another.
In the future, standardisation and automation will change this, and mean there will be fewer people involved in managing the operational complexities resulting from trading these types of instruments.
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