Pensions still fight shy of derivatives: Fear and greed have left the City a long way behind US counterparts, reports Peter Krijgsman

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The Independent Online
DERIVATIVE financial instruments - especially futures and options - are slowly losing their bad image among UK investors. But British fund managers have a long way to go to catch up on their US counterparts.

This slow start is due to the usual mix of fear and greed: greed, because UK fund managers have historically enjoyed much higher returns in the gilt market than their counterparts in the US so there has been less pressure to enhance yields via derivative strategies.

Fear, because there is still a gulf of ignorance between the rocket scientists and boffins of the investment banks inventing derivative products on one side, and the pension fund trustees and fund managers on the other.

Some bankers also list the UK's heavily regulated environment as a brake on progress, although John Major's one Budget as Chancellor of the Exchequer removed many of the obstacles by clarifying the tax status of derivative instruments.

Mr Major's legislation confirmed that no tax would be payable on the proceeds of futures and options bought and sold by pension funds.

His move was a positive encouragement not least because a pension fund can deal as often as it likes in derivative products but incur no tax charge, while if it deals its share portfolio too frequently the Revenue could claim that it was trading rather than investing for the long term, and tax the capital gains.

This encouragement notwithstanding, John Rogers at the National Association of Pension Funds concedes that derivatives are not used extensively by UK pension funds, but says that their use is increasing. 'We want to encourage that use, provided that fund managers and trustees are happy,' he says.

The NAPF is working with the London International Financial Futures and Options Exchange (Liffe) and the Futures and Options Association (FOA) to provide an educational programme for trustees and fund managers.

For the past three years the two bodies have been running a joint one-day workshop. Roger Barton, director of business development at the exchange, confirms that education is Liffe's main focus of activity with investors at the moment.

But signs of real activity are beginning to emerge. Greenwich Associates, the US financial market research boutique, interviewed nearly 300 UK tax-exempt funds in April and May of 1993, all of them with assets over pounds 50m.*

Greenwich found that 19 per cent of the pension funds interviewed invested in derivatives 'directly to implement investment decisions'. A much greater number, 34 per cent, did not allow their fund managers to use derivatives at all. The largest group, representing 41 per cent of the sample, allowed external fund managers to use derivative products at their discretion.

Local authority pension funds, no doubt mindful of the Hammersmith and Fulham interest rate swaps debacle in the late 1980s, are the biggest abstainers, with only 5 per cent investing directly in derivatives and 49 per cent expressly prohibiting their use.

The heaviest users, proportionally, are UK corporate pension funds; 25 per cent use derivatives directly and 31 per cent prohibit their use.

Greenwich also asked the funds about their future intentions. In each category the plan is to increase the use of derivatives, either directly or through their appointed asset managers.

Local authorities remain the most conservative, with only 8 per cent expecting to invest in the products directly, and 43 per cent expecting continued prohibition.

The most popular instrument amongst mainstream fund managers who do use derivative products appears to be futures, especially as a way of enabling asset allocation decisions. Lough Callaghan, a director of Mercury Asset Management, says that futures are an efficient means of moving portfolios in and out of geographical markets.

A few pensions funds occasionally use options in a limited way to support a view of a share price. For instance, a fund manager might look at a share supported by a high dividend and consider it to have limited downside.

The manager could sell a put option at a price of 5 per cent to 10 per cent below the consent price, earning a premium for writing the put. If the share price falls, the manager has to buy the stock: a reasonable risk if it continues to be supported by its yield. The return enhancement comes from writing the premium.

But options seem to have limited popularity. 'Writing options is a mug's game from a fund manager's point of view,' said one investor, 'mainly because our performance is judged against an index. If the market rises, and we're not there because we've been writing call options, nobody is going to thank us for the premium income.'

The most public example of a UK investing institution using derivatives so far is the Foreign & Colonial-Hypo Bank unit trust.

Launched at the beginning of last March, the fund has attracted pounds 470m from retail investors seeking a high yield. This has so far been achieved with an annualised yield of 10 per cent. The F&C fund is invested 55 per cent in blue chips and 45 per cent in cash and debentures. The debentures form the base of a traded options strategy within the fund - that is earning premium income by writing puts and calls on the equities held by the fund. The premiums are distributed through the debenture to the unit-holder.

A similar fund was launched by Morgan Grenfell in September, but so far these two are the only prominent examples of derivatives being used to attract retail investor funds.

But given the likelihood of continuing low yields from more traditional investments, it is unlikely that they will have the field to themselves for long.

* UK Pension Funds 1993 - Onward & Upward. Greenwich Associates. Tel. 0101 203 629 1200

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