Derivatives - power tools for pension funds.

Derivatives are quickly becoming the instruments of choice for pension funds that want to strategically manipulate their risks. But you must choose your weapon carefully.

Derivatives, once labeled a mere adjunct to stocks and bonds, are fast becoming standard operating procedure for many U.S. pension funds. Derivative use is growing rapidly because these instruments have powerful and broad consequences for portfolio management. They actually permit the plan sponsor to manipulate the shape of the expected return distribution.

Plan sponsors have long invested in a broad range of asset classes to create returns that best offset the range of liabilities they face. In general, earning better returns required either changing the asset-distribution mix or hiring and firing managers. With either method, the return distribution was generally symmetric, at least with traditional securities classes. But with some help from derivatives, managers and sponsors can remove, truncate, emphasize or control risks both tactically and strategically.

For newcomers to the field, a derivatives instrument is a bilateral contract or payments-exchange agreement whose value is measured by the value of one or more underlying instruments, reference points or markets. The term covers a broad range of instruments ranging from options, futures and forwards to customized swaps and combination instruments, such as collars and structured notes. Many investment managers use derivatives to hedge on option overriding programs or to time the buying and selling of securities to keep fully invested. In addition, some managers and sponsors trade bond and index futures to change or rebalance portfolio weightings before buying the underlying securities. However, as plan sponsors increasingly use derivatives directly, the real growth will be in the over-the-counter derivatives markets.

That's because derivatives possess several important attractions for pension-fund sponsors. Once you overcome the initial policy and procedural hurdles, they provide faster and cheaper ways to implement strategies. For example, you can buy a structured note to get into a foreign or international market without hiring a consultant, a global custodian or an expensive investment manager.

In addition, derivatives also let sponsors fine-tune their results or hedge out undesirable aspects of the manager's performance. That's an important plus, because hiring and firing managers can be a very expensive way to alter policy. Derivatives, like equity swaps, may enable a plan sponsor to capture a view on a market without disrupting the underlying manager. They also allow sponsors to combine swap strategies to earn substantial basis-point returns by taking modest incremental risk.

Derivatives can be used to rebalance a portfolio quickly to gain exposure to an illiquid asset class, again without removing the fund managers. They can help sponsors reach markets that the fund cannot enter directly, either because of plan constraints or because the market is illiquid or too small. For example, certain public funds are interested in international investing but are restricted by state law from investing in international equities. Derivatives allow them to reach these markets through structured-note products that are fixed income-like instruments that carry the return of selected international instruments.

READ THE INSTRUCTIONS FIRST

Of course, to use any new tool effectively, you must understand it, and derivatives are particularly daunting in that respect because they were originally created to help counterparties with unequal financial, regulatory, investment or economic outlooks exchange risk and return among one another. As a result, the applicable derivatives solution depends on the many disparate financial problems that corporate treasurers, pension officers and others face in the marketplace. Pension funds and their advisors need a better understanding of their own tolerance for various types of risks, as well as the instruments available to them, to make informed choices.

For plan sponsors used to hiring investment managers at a disclosed rate, dealing with counterparties who won't divulge their returns on derivatives transactions can be discomforting. Most swaps involve taking counterparty credit risk, but those risks are controllable. The plan sponsor can select AA-rated (or better) counterparties, or it can settle the swap transactions more frequently, thereby diminishing the amount of exposure.

In addition, for many plan sponsors, the counterparty may have additional fiduciary relationships with them. Therefore, the transaction may require a QPAM, or qualified professional asset manager, to make sure that one of the parties isn't prohibited from entering into the transaction. As plan sponsors adopt derivatives, the number of qualified QPAMs is increasing dramatically. The Department of Labor is considering an exemption for in-house investment managers, and specific applications are pending that would allow counterparties to enter into certain types of derivatives.

Recently, the "Group of 30," a global think tank whose members include representatives from financial institutions, academia and the federal government, published a study called "Derivatives, Practice and Principles," which deals with various derivatives issues. The study's most important contribution has been to define a sound risk-management practice for dealers and users, and it offers several important recommendations to help them manage derivative activities. These recommendations were designed to help the participants benchmark their procedures and those of their counterparties.

First, the scope of a fund's involvement in derivatives should be a senior-level decision, according to the study. It also stresses the appropriate valuation of derivatives positions at market, at least for risk-management purposes. You should know the economic value of the positions you hold and how those might change periodically. Actively and frequently evaluate your counterparties' credit quality, measured in terms of current and potential exposure. This is a very big issue. Next, reduce credit risk by broadening the use of multi-product master agreements with close-out netting positions. Netting is an extremely effective tool to lessen risk.

THE NUTS AND BOLTS 

The study also cautions that you need good management information systems to measure, manage and report risk promptly. Great reports that reveal your exposure to an event well after it's happened don't give you much in terms of risk management, nor do they enable you to take advantage of what those risks might provide. The study advocates voluntarily adopting disclosure practices that make your financial reporting better reflect what you're doing in derivatives.

You can really add to the stability of the market by specifically looking at your internal practices and those of the parties you deal with. If you insist on operating within these guidelines, you'll contribute greatly to a more balanced marketplace.

Also, ensure that your dealer can quantify market risk well. Dealers should have a strong, independent risk-management function to cover issues like risk-limit policies. And the dealer should have a good credit risk-management function for approving, monitoring and reviewing credit limits and concentration on counterparties. A good credit-review process to ensure that the dealer reviews other counterparties carefully is important. While you won't get to see the other counterparties, at least you'll be comfortable that a good process is in place to make sure nobody gets in under the fence.

Confirm that your dealer employs talented, well-trained professionals with plenty of backup. You should also be confident about the management's knowledge of derivatives and the business context in which they'll be used. Your counterparty should be able to demonstrate to your satisfaction that it's going to benchmark well against the study recommendations.

Don't use derivatives strictly on price, because you really ought to be more concerned about some of the other qualitative elements. The use of derivatives should be consistent with how your firm deals with risk and capital. Don't wait for an appealing opportunity to use derivatives and then deal with senior-management-approval issues. Formulate a policy that will enable you to act proactively.

Next, measure your credit exposure. The counterparty risk is an extremely important issue. Don't underestimate the impact that the counterparty has on your transaction's liquidity and value. Whenever you enter into a transaction, you should always think about how you can exit if that becomes necessary.

Finally, use one master agreement with each counterparty to provide for closeout and settlement netting. These agreements can substantially reduce the risk to which you expose your fund or firm. No single guideline or response will answer all your questions on the over-the-counter derivatives market clearly. As the Group of 30 study points out, regulators have conducted numerous studies into the implications of derivatives for the market. While none of those efforts concluded that derivatives significantly increase systemic risk, neither did they suggest that we can all become complacent.

As you can see, derivatives are clearly changing the financial landscape fundamentally. By enabling pension-fund managers to define, quantify and control risk in a highly sophisticated fashion, derivatives have opened the door to whole new frameworks of financial practice, forcing all of us to confront and manage risk in a very new way. As with any tool, it'll take practice to learn to use them well. Take a look at the accompanying scenarios for a trial run on some common derivatives transactions.

Mr. McCord and Mr. Martin are managing directors, respectively, of retirement services-derivatives and global assets retirement services at Bankers Trust Co. in New York.