Australian superannuation funds are increasingly using derivatives to protect their investment portfolios and gain exposures not available through direct investment according to research by risk management and retirement specialist firm, Milliman.
The survey revealed that roughly four in five funds (79 per cent) used derivatives ‘always’ or ‘often’ for risk management and hedging, along with management techniques like portfolio rebalancing and assisting with fund manager transitions.
“Most super funds are using derivatives not only for risk management, but for dynamic asset allocation, physical security replacement and to enhance yield, Milliman Head of Fund Advisory Services, Michael Armitage, said.
The research “found no signs that derivatives were being used to take on excessive risk with 85 per cent of funds stating they ‘never’ used derivatives to leverage exposure”, Mr Armitage said.
That means that funds were not using derivatives to double down on bets, rather they were being used to offset exposures.
The most popular method to employ derivatives was through an overlay structure (65 per cent), followed by an external manager mandate (47 per cent), and as a core component of asset allocation (26 per cent), Millman found.
“Risk management and hedging continue to be main areas of derivative usage. However as an ageing population is faced with increasing exposure to sequencing risk (progressive payout needs through life) and demand more retirement-focused products, funds will increasingly turn to more explicit portfolio protection strategies using derivatives to manage more complex retirement dynamics,” Mr Armitage said.
Insurers and defined benefit funds face similar asset-liability challenges and use derivatives to cope with them. Derivatives are also increasingly being used to improve long-term outcomes and minimise short fall risks to individuals using financial planning platforms, he said.
Some 69 per cent of MySuper funds and 63 per cent of choice/pension products don’t use any explicit downside protection strategies despite what Millman saw as the global financial crisis exposing the limitations of diversification as a risk management strategy, Mr Armitage said.
The Comprehensive Income for Retirement Products (CIPR) discussions implemented by government and regulators can be expected to increase interest in derivative useage as it will bring focus on the changing needs of individuals through the pension cycle of their retirements.
The end of the low interest rate environment which will likely lead to bond price falls are a worry for the retirement industry.
“Funds utilising downside protection in the pension phase are expressing growing concern with fixed income’s ability to provide diversification benefits given a potentially rising rate environment, Mr Armitage said.
Others are focused upon managing investor behaviour and smoothing portfolio performance to help members achieve their retirement goals.”
Overall, for funds that chose not to use derivatives, 32 per cent believed they could meet their objectives without them, 18 per cent were concerned that the complexity outweighed the benefits, and 9 per cent cited the negative perception surrounding derivatives.
Milliman’s financial risk management division, Milliman FRM, is a global firm providing advisory, hedging and consulting services to the retirement savings and insurance industries. It manages US$152 billion ($A198.49 billion) in global assets as at 30 June 2017.