In From The Cold – The Buy-Side Use Of Derivatives
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.