Written By: Masroor Ahmad
& Mark Davies
Brakes, on the face of it, slow you down. But the fact that your car has them means it is safe for you to drive more quickly. Masroor Ahmad and Mark Davies of River and Mercantile explain why using derivatives as a risk management tool could contribute to higher investment returns when implemented properly
Basic brakes are simple, but give you confidence. They are fundamentally as simple as pads against a wheel, as easy to apply as stepping on a pedal, and deciding when to use them is a rudimentary skill: if the road starts to wind, use them to slow down. And using brakes, as a way to avoid a crash, is far safer than trying to steer your way out of trouble. The brakes increase your confidence in driving the car, which ultimately means you are happier travelling at a faster speed – how happy would you be at 70mph on the motorway with no brakes?
Better brakes can save you time
One of the significant developments in Formula 1 in the last 30 years has been the increase in braking power. Whilst powerful brakes might seem to be about the opposite of driving fast, it has actually had the impact of reducing lap times. Why is this? If a Formula 1 car can slow from 180mph to 60mph at twice the rate – in three seconds as opposed to six – then, in a lap of about one-and-a-half minutes, it has made a significant improvement to its performance.
Braking skills still add value
Although the basic skill of deciding when to brake is rudimentary, it is a skill that can be developed to quite a sophisticated degree. Faced with the challenge of extracting maximum performance at all times, professional drivers’ core skill is in the ability to use their brakes to help them around racing circuits smoothly, which, again, helps reduce their overall journey time.
Clearly, the pursuit of maximum performance at all times is not relevant to everyday drivers. But the principles behind it still apply, meaning that effective braking systems coupled with skilful implementation will help a driver reach his or her destination safely in a significantly reduced time.
What has this to do with pension schemes?
Pension schemes are not hugely different. Their deficits require them to achieve a certain level of performance – a minimum investment return – so going too slowly will result in a failure to meet their objective of eliminating their deficit. Yet market crashes can be extremely painful. The approach pension schemes have typically taken to manage this risk is to rely on skill, whether that is through advice on diversification, active asset allocation or traditional active management. But this is the equivalent of relying on steering to avoid an accident, and, as a result, it is difficult for pension schemes to have confidence. So pension schemes are likely to have historically driven slower – targeted less return – than they needed.
Derivatives are often associated with risk management, and risk management is often associated with sacrificing return for lower risk. However, as with brakes, the use of derivatives can actually help pension schemes not only manage the risk of accidents but also contribute to their performance objective. And just as high-performance brakes used to be expensive but are now more cost effective, derivatives are now affordable for most pension schemes.
Derivatives can add to overall performance
Let us imagine a world where, over three years, the equity markets fall 30%, followed by a three-year period in which they rise 100%. An investor (that starts with £100 say) who can avoid the 30% market fall will clearly outperform an investor who can’t. In addition, as the investor that was protected from the fall has a higher asset base after three years (£100, rather than £70), then, even if it only gets a 60% return in the subsequent three-year period, it will still end up with more assets than the unprotected investor (£160, rather than £140). So avoiding the market fall, a risk management strategy, can add significantly to the overall performance a scheme achieves. This type of result is entirely feasible with derivative strategies such as “structured equity”.
Too good to be true?
We often get asked “what is the catch? This sounds too good to be true” which is a valid question. To a certain extent, relative to traditional tools of equities vs. bonds, it is too good to be true but the point is that pension schemes now have tools available to them that were not available before. The Formula 1 cars of today can do things that couldn’t be imagined 50 years ago. Similarly, pension schemes today have more tools at their disposal, and these should be factored into trustees’ visions of what is possible. Derivatives were once the exclusive preserve of large institutions that could afford the high costs involved, but this is no longer the case. Derivatives are now being used by schemes of all sizes. And in today’s choppy markets, they are more useful than ever. But the challenge with new tools is the fear of complexity.
Complex ideas need simple explanations
Let’s keep the transport analogies going. One example of how thinking has changed dramatically over the past 50 years is transatlantic travel. Not long ago the received wisdom was that the only way to travel to New York was by ship, whereas now few would consider going any other way than by plane – and 20 times more people fly to New York from London today than in 1975. Clearly this switch didn’t happen overnight. We had to think about things differently, get comfortable with “new” ideas and make those ideas more accessible.
The challenge with new ideas is that they are often associated with increasing complexity. This is as true in the pensions industry as it is in deciding whether to fly to New York or sail. When you drill down into the detail, a ship, a plane and a pension scheme strategy are all incredibly complex, as is the decision of which to favour.
We would argue, however, that the challenge is not the complexity of the solution but rather of the explanation. A plane is not a trivial thing to design and build and, trust me, the maths behind a plane is significantly more challenging than that of derivatives. However, we would hazard a guess that far fewer people reading this would be happier to use derivatives than get on a plane.
People around the world have grown comfortable with what a plane should look like – two wings, engines and a tail are basic requirements. The airline and type of plane may be other considerations. There is no right answer, but the point is that governance and decision-making has been made easier for people. The complexity of the vehicle is no longer the problem: explanation and governance of the complexity is. We should strive to do the same with derivatives for pension schemes.
Far too often providers will produce pages of complex charts and clever phrases and hope that trustees will buy into the cleverness of the complexity. Equally, schemes may throw out ideas immediately because of the very same complexity. Trustees should challenge their advisers and managers to explain things in a way that is straightforward. Providers should rise to this challenge and not be afraid to start out simply and help trustees build their knowledge and familiarity with the subject.
Then, together, we may find many more tools at our disposal to help us better address the challenges we face. In this way the ideas that otherwise seemed as complex and dangerous as flying in the last century may just become accepted practice that can contribute significantly to the needs of today’s pension schemes.