Orange County Employees Retirement System
Strategic Investment Solutions, Inc. (SIS) was retained by the County of Orange Board of Supervisors (OC) to accomplish four tasks:
§ Review the portfolios of any and all money managers utilizing leverage, derivatives, currency futures, commodities, hedge fund investments, or other alternative investment practices. As part of this review, determine the levels of risk (including counterparty risk) and return associated with any of the aforementioned vehicles.
§ Provide a brief comparison of the overall risk exposure in the OCERS Retirement Fund relative to other Retirement Systems of comparable size.
§ Prepare a written report on the analysis, findings and recommendations.
§ Meet and advise County staff, the Orange County Board of Supervisors, and the Orange County Employees Retirement System (OCERS) Board on the study results and recommendations for best practices.
OC Treasurer Chris Street, in a memo to Supervisor Chris Norby, dated April 3, 2007, expressed his concern regarding OCERS’ Investment Policy use of leverage and alternative asset classes. Since that memo, OCERS has taken numerous steps to address the concerns expressed by Treasurer Street. Central to the actions taken by OCERS was a review of Investment Policy and Practices by the fiduciary counsel.
Reed Smith’s “Report on the Investment Policies and Procedures of the Orange County Employees Retirement System,” dated March 2, 2008, made five specific recommendations and numerous best practices improvements for consideration. OCERS prepared a response to the report that was delivered to the members of the Board of Retirement on May 8, 2008. The report and response were ultimately shared with OC.
SIS decided not to duplicate the Reed Smith effort, but to focus on derivatives — their risks, uses by investment managers, guidelines governing their usage, and the monitoring of their usage. Reed Smith reported that “OCERS’ overall investment process is reasonable and prudent and consistent with the core best practices for the defined benefit plans of public employee retirement systems.” SIS agrees with this statement. That being said, we also have some specific observations and recommendations that can further OCERS’ oversight of the uses of derivatives and hopefully reduce the sometimes unintended consequences of usage by its investment managers.
SIS appreciates the opportunity to be of service to the OC Board of Supervisors and the beneficiaries of OCERS. We trust that you will find our study to be both illuminative on the subject of derivatives and constructive in our recommendations and believe this study will help the OC Board of Supervisors gain a higher degree of confidence that OCERS understands derivative instruments and is monitoring its use.
II. OCERS’ USE OF DERIVATIVES
Using derivatives has two primary advantages:
§ Trading derivatives can lower transaction costs versus trading physical securities. Futures and forwards will be favored by managers if they can be more efficiently implemented than using physical securities.
§ Derivatives facilitate changing the structure of a portfolio leaving intact existing holdings which may be attractive from a risk/return perspective or from a view of availability of the security. A portfolio manager can buy a security even if that security alters the desired portfolio structure because futures and forwards can be used to correct to the desired portfolio structure.
There are two broad problems with many derivatives. One is lack of transparency and another is what we will call the “laws of unintended consequences.” It is normally impossible to look at a portfolio and know which securities are derivatives and what their values are based upon. Monitoring the notional derivative exposure is not a very effective risk control system. Options-based and forwards-based instruments have different risk levels and should be evaluated accordingly. Exchange-traded futures and options are readily priced, liquid and have limited unintended consequences. Over-the-counter swaps and derivatives require more careful usage and control as they lack transparency, introduce counterparty risk and can compound a poor investment decision at an exponential rate.
How do investment managers generally use derivatives to implement strategy?
Generally speaking, OCERS’ fixed income investment managers use forward and futures contracts to control interest rate exposure, yield curve risk and currency exposure of fixed income portfolios. For example, a portfolio manager may be interested in buying a particular bond from an attractive issuer even though the maturity date of that bond is long-term and alters the desired duration of the fixed income portfolio. The manager takes advantage of the availability of the bond and corrects for the maturity impact by using forward or futures contracts to correct the duration profile of the portfolio.
Should a portfolio manager desire to protect the portfolio against a rise in interest rates, there are two alternatives available. First, an obvious action is to sell existing holdings and buy shorter-term bonds to reduce the portfolio’s duration, an often expensive decision. Second, leave the holdings intact and sell bond forwards or futures contracts to hedge the portfolio from declining as interest rates rise.
Conversely, if a portfolio manager believes that interest rates are going to fall, the portfolio duration can be temporarily extended using forwards or futures contracts. In either action, the main risk is the profit or loss associated with the forwards and futures and not the notional exposure. The clearing house sets and maintains the margin, generally equal to the maximum daily price fluctuations allowed for the contract being traded. Again, the benefits are lower transaction costs and an ability to maintain the characteristics of the existing holding through low cost, exchange traded, derivatives. Investment managers consider the cost of executing trades in the cash market versus using derivatives to alter portfolio characteristics.
Many of OCERS’ fixed income managers utilize various swaps to adjust the portfolio’s duration as interest rates fluctuate. One common type is an interest rate swap which is used to adjust the overall duration of the portfolio. In a very simple interest rate swap, one counterparty agrees to pay a pre-determined fixed interest rate in exchange for a floating interest rate paid by the other counterparty over the term of the swap (tenor in industry jargon) on a notional amount of principal. For example, the manager may find a collection of bonds that they find very attractive on a relative value basis, however after they purchase these bonds the resulting duration of the portfolio may be outside the allowable duration band vs. the benchmark. To remedy this, the manager would enter into a series of interest rate swaps designed to lower the portfolio’s duration to an acceptable level. For a holder of bonds with fixed interest rates, or coupons, entering into a pay-fixed/receive-floating interest rate swap effectively converts a portion of the fixed interest payments from the underlying bonds into floating-rate payments, which in turn reduces the duration of the overall portfolio. This is because the interest rate on floating-rate instruments resets periodically, so these securities have a lower sensitivity to interest rate movements (i.e., a lower duration) than fixed-rate bonds. Thus through the use of interest rate swaps, the manager is able to increase or decrease the portfolio’s duration without having to trade underlying cash bonds and incur significant transaction costs.
OCERS international equity managers use equity index futures contracts regularly to adjust their net country exposure, i.e., they are long equities in a given country but are short futures on a broad index in the same market to remove or reduce unwanted country exposure. This allows them to add alpha (hopefully) through the selection of individual stocks while at the same time removing exposure to that country’s broader equity market. The risk of using futures contracts revolves around the rules of the exchange. If the market is volatile, the contracts may reach their daily fluctuation limit set by the exchange and trading may be halted for a period of time. If the contract remains suspended, then settlement may be forced to take place. International equity managers also use forward contracts to hedge unwanted foreign currency exposure back into the U.S. dollar. To allow a safety margin for market fluctuations of the corresponding equities, a manager may limit hedging to 90% of all foreign currency exposure and a further limit 90% of the value of the exposure in each country's currency. Thus, if a currency that has been sold forward rises there would be a loss on the forward contract which would be almost exactly offset by a currency gain on the underlying equities. Similarly, if the currency falls there would be a gain on the forward contract which would, however, be almost exactly offset by a currency loss on the underlying securities. Using currency forwards allows the manager to maintain the desired exposure to foreign-currency denominated stocks but remove much of the associated currency risk.
With the exception of one manager who uses derivatives to equitize cash, OCERS U.S. equity managers do not use derivatives.
III. Summary FINDINGS
A. OCERS Total Risk Versus Peer Group
The scope of work calls for a comparison of the overall risk exposure of the OCERS Retirement Fund relative to similar retirement systems. At its most fundamental, risk exposure can be illustrated by total fund standard deviation through the eyes of an asset allocation model. So using SIS’s latest capital market expectations, we compare the expected risk and return of OCERS’ target asset allocation with the risk and return of the average asset allocation of a comparable universe. Our analysis shows that the expected return and risk of the OCERS portfolio are slightly lower than those of the universe. The expected return of the OCERS portfolio is 8.36% while the expected return of the universe average is 8.63%. The expected standard deviation or risk of the OCERS portfolio is 9.2% with the expected risk of the universe average is 11.1%. So, from a strategic view, the risk being taken by the OCERS portfolio is lower than that of its -peers. If we examine the excess return (return above the risk free return) per unit of risk being taken, the OCERS target has the higher expected return per unit return of risk taken of 0.53 versus 0.46 for the peers.
Another way to compare risk exposures is a direct evaluation of the difference in the asset class target weights. The following table shows the target weights of OCERS and the average asset allocation of their peers.
Peer Group Average
Emerging Mkt Equity
A couple of characteristics of the OCERS asset allocation standout, no asset class is more than 19% of the fund and no asset class is less than 5% of the fund. The fund has taken on the characteristics of very broad diversification; don’t put all your eggs in one basket, a characteristic that more and more funds are beginning to adopt and which was explicit in the planning and development of this strategic policy mix.
However, the OCERS portfolio is significantly different from its peers, primarily 20+% less in US Equity than its peers and that 20% is spread out across other asset classes, in which OCERS peers do not have significant allocations. This includes a 10% allocation to an inflation hedging, Real Return asset class which most funds were beginning to consider prior to recent market events. Since OCERS allocation is significantly different from its peers there will be periods where OCERS performance will be significantly different, both positive and negative, from its peers, particularly when US Equity performs well. Again, OCERS recognizes that potential and is willingly taking the peer outlier risk in the interest of reducing the risk and volatility of asset returns.
Another aspect of the asset class and total fund analysis is the aggregation of derivative exposure and leverage at the asset class and total fund levels. There are two reports to the OCERS Board, prepared by staff, which summarize the derivative exposure and leverage for the total fund. The OCERS Financial Statement, which is provided monthly, includes a section under the GASB 40 reporting that provides four pages of information on all the derivatives in the plan. Second, OCERS Staff prepares a memo quarterly on the derivatives exposure and leverage used within each of the asset classes which is provided to the OCERS Board.
In our opinion, the OCERS Financial Statement reporting on derivatives does not provide much information of the impact on the OCERS portfolio risk due to these positions. For all the instruments, the asset class, index or financial characteristic upon which they derive their performance, value and risk are not stated. Furthermore, examination of the derivatives positions in isolation provides no information on why they are in the portfolio. Are they there to hedge a similar risk or to gain exposure or to enhance the return of the portfolio? So, it’s really impossible to determine what impact these positions have on the overall risk and return of the OCERS portfolio.
When an investment manager’s style and strategy necessitates the use of derivatives, OCERS should require each manager to identify in advance the instruments to be utilized. OCERS should also request that the manager explain their purpose and use. From this information, investment guidelines may be designed to mitigate unintended risks due to managers taking portfolio risks beyond OCERS’ expectations when the manager was hired. In particular, controlling the degree to which a manager may employ exotic risk to achieve excess return. A central tenet of investment manager guidelines is that the managers’ signals are also their incentives and boundaries that the fund sponsor is responding to as the ultimate owners of the assets. The investment policy guidelines document and communicate trustees’ beliefs, objectives, risk tolerance and necessary transparency to the manager and other interested parties. A well written guideline documents the manager’s investment strategy, process, the nature of the underlying investments, and the applicable benchmarks used to measure the performance. And lastly, the document should describe the reporting requirements of the manager.
B. OCERS Manager Specific Risk
The scope of work also calls for a review of the use of derivatives and other alternative investment practices by external managers. In our review of individual managers, we focused on the use of derivatives, leverage and shorting. Where derivatives are used extensively we reviewed risk management procedures including collateralization, counterparty risk and pricing of OTC transactions. Finally, we comment on how these strategies are addressed in the manager guidelines and the adequacy of reporting OCERS receives addressing managers’ use of derivatives.
A summary of our findings on an individual manager basis follows. We first address the managers where derivatives, leverage and/or shorting have a significant role in the investment strategy. The remaining managers are addressed by asset class.
Bridgewater Associates, Inc. Hedge Fund Strategy
Use and Rationale: Bridgewater almost exclusively uses derivatives in the OCERS portfolio. They employ equity market, interest rate, commodities futures & swaps as well as currency forwards. A moderate amount of leverage is obtained through derivatives (vs. borrowed money); some financial leverage is obtained through repurchase agreements. They also use outright short positions. Bridgewater uses derivatives to maintain liquidity and lower transaction costs. Futures contracts are used primarily to separate country and currency decisions.
Risk Management: It doesn't appear that Bridgewater positions are fully collateralized. Pricing is done independently by the custodian. Bridgewater reconciles the valuation with the custodian each day. Standard procedures are in place for resolving pricing discrepancies.
Guidelines: Bridgewater adopted OCERS guidelines on 4/25/05. Investments are made through three commingled vehicles which are not bound by the guidelines included in the OCERS/Bridgewater IMA. The guidelines include minimum ratings on swap counterparties yet because OCERS is invested in the commingled fund, Bridgewater is not bound by this guideline. No leverage target or limits are specified in the offering documents.
Reporting: Bridgewater provides a moderate level of detail, although several of the strategy sleeves report just one line item (Equity Sectors, Options, Event Risk, Commodities). In addition, it is difficult to determine the amount of leverage being utilized (only net exposure is reported) or the composition of the portfolio (i.e., cash securities vs. derivatives – would expect that the holdings are almost all derivatives with the exception of TIPS). Finally, it appears that the exposure, as a percentage of portfolio value represents the full notional value of the underlying derivatives but this is not explicitly stated.
PIMCO: Most Strategies
PIMCO manages four strategies for OCERS including (1) a Core Plus Full Authority Fixed Income portfolio, (2) a Real Return Full Authority portfolio, (3) a Distressed Mortgage portfolio, and (4) a Commodities Plus portfolio. The following comments apply generally to all four strategies.
Use and Rationale: PIMCO uses derivatives to reduce costs of accessing certain securities, separating and isolating risks, obtaining or hedging exposures. No transactions are specifically prohibited. PIMCO has full discretion to use any type of derivatives, leverage and shorting however each portfolio is limited by the duration constraints and concentration limits.
Risk Management: Potential counterparties are analyzed to according to the following criteria: reputation and history of management, past experience dealing with PIMCO, quality of market skills, percentage of market participation, availability of financial information and other factors. PIMCO’s positions are fully collateralized with the exception of money market futures which are marked-to-market and cash settled daily with no deliverable instrument upon expiration. PIMCO will reconcile pricing with the custodian who may use a vendor for pricing. If the custodian or vendor can’t supply a price, PIMCO will provide the price.
Guidelines: OCERS last amended their guidelines with PIMCO on the following dates: (1) a Core Plus Full Authority Fixed Income portfolio 12/1/06; (2) a Real Return Full Authority portfolio 4/6/04; (3) a Distressed Mortgage portfolio 9/21/07; and (4) a Commodities Plus portfolio 2/27/08.
Generally speaking, investments in common stock and equity futures are prohibited; other than this, PIMCO can invest in just about any type of security or derivative. No transaction types are explicitly prohibited. Currency forwards can be used for hedging and outright active positions, regardless of the underlying assets. No guidelines specifically address leverage.
Reporting: PIMCO reports are through but the format could be more “usable”. PIMCO has by far the most complex portfolio, so there needs to be a balance between accurately presenting exposures and information overload. As it now stands, the “Portfolio Summary” and “Derivatives Summary” reports do not adequately portray what’s really going on “underneath the hood”.
AQR Capital Management: International Equity
Use and Rationale: AQR uses equity index futures, equity market swaps, spot and forward currency contracts as a part of their international equity strategy to separate stock, country and currency risk. Stock index and swaps are used to implement country selection. Currency forwards are used for currency overlay. While they are technically levered, net leverage (defined as total long positions plus notional derivatives held long less notional derivates held short is greater than 100% market value) is not employed. Shorting is limited to the total notional long exposure (no net shorting).
Risk Management: The account is not fully collateralized as a result of the separation of the currency and security selection decision. It appears AQR prices the securities and gives this information to the custodian which creates a potential conflict of interest. If the client disagrees, the custodian is informed.
Guidelines: AQR adopted the OCERS guidelines on 1/8/07. Derivatives are explicitly allowed. Specifically “equity swaps, equity index swaps, spot and forward currency contracts, futures and other derivative contracts” are allowed. Net leverage cannot be greater than 100%, but gross leverage greater than 100% is not prohibited. Short positions are allowed, specifically in equity derivatives; net short positions in any country are prohibited, i.e., net leverage (defined above) greater than or equal to 0% for any given country. Net foreign currency exposure must be ≤ 100% and net short exposure to any given currency is not allowed. Language concerning guideline violations is very open to interpretation, e.g., if there is a “non-trivial deviation” and AQR rectifies it as soon as practicable and notifies the client, this situation would not be deemed a breach of contract.
Reporting: Report is very usable and succinct with cash securities broken down by country listed alongside the notional derivatives exposure, net exposure and difference vs. the benchmark.
Aberdeen Asset Management: US Core Plus Fixed Income
Use and Rationale: Aberdeen uses derivatives as a substitute for buying or selling securities to enhance returns. Aberdeen does not describe their use of leverage in this strategy, but they do short securities for hedging purposes. Outright short positions are implemented using CDS; however, no physical securities are shorted.
Risk Management: Counterparty due diligence is conducted by Aberdeen’s Risk Control Division. "Periodic" reviews are conducted using the latest financials from the relevant trading counterparties. Credit worthiness of OTC counterparties is assessed using published credit ratings. It is not clear from Aberdeen’s RFI response whether or not derivative positions are fully collateralized. Derivatives pricing methodology is also unclear. It appears that State Street prices the derivatives and provides this information to both the manager and client.
Guidelines: Aberdeen adopted the OCERS guidelines on 1/4/07. All manner of derivatives can be used for hedging purposes, to modify aggregate risk exposures and to create synthetic positions, both long and short. Currency forwards can be used for hedging and outright active positions, regardless of the underlying assets. Proceeds from TBA rolls may be invested in short duration pooled funds. Aberdeen pooled funds (International, Emerging Markets, High Yield) are used for “plus sector” exposure, each of which has its own guidelines that supersede OCERS guidelines. OCERS guidelines do not specifically address leverage.
Reporting: Aberdeen’s reporting could be more transparent. The look-through to the "plus" sector pooled funds is lacking. The derivatives report is detailed and includes notional exposures, but there is almost too much detail. In addition, the derivatives report is stand-alone and does not integrate with the rest of the portfolio holdings so there is no sense for how the derivatives complement or offset any of the physical holdings of the portfolio.
US Equity Managers
Barclays Global Investors
Use and Rationale: BGI limits their use of derivatives to equity index futures and synthetic cash positions in the securities lending cash collateral pool. They do not use leverage or shorting. BGI uses derivatives primarily for securitizing excess cash.
Risk Management: All derivatives are fully collateralized. BGI has a dedicated risk management groups in each location and uses proprietary risk controls in their portfolios. Counterparty risk is addressed with BGI's Global Credit Group (GCR) acting as a fiduciary and on a collateralized basis for all OTC derivative activity. The Global Credit Research Group evaluates counterparty credit and determines counterparty limits. Derivatives are priced by the custodian.
Guidelines: The original account was with Wells Fargo and dates back to 1986. The first set of BGI guidelines are dated 6/11/03, although they are the Third Amendment. The only stated restriction is that the funds will not engage in "speculative futures transactions.
Reporting: Current reports don’t break out cash securities vs. derivatives but does list total exposure. In order to obtain full transparency, the report sould show cash securities and derivatives (if utilized) separately, list the notional exposure of the derivatives, and also indicate the collateral that’s backing the derivatives positions.
Cadence Capital Management does not use derivatives, leverage or shorting for this strategy. Cadence’s guidelines were adopted on 12/30/97 and last amended 3/24/08; however, they do not reference derivatives, leverage or shorting.
Capital Guardian does not use derivatives, leverage or shorting for this strategy. Capital Guardian’s guidelines were adopted on 11/15/99 and were last amended on 8/29/06; however, they do not reference derivatives, leverage or shorting.
Dodge & Cox does not use derivatives, leverage or shorting for this strategy. Dodge & Cox’s guidelines were adopted on 12/30/97 and last amended 8/26/06; however, they do not reference derivatives, leverage or shorting.
Peregrine Capital does not use derivatives, leverage or shorting for this strategy. Peregrine’s guidelines were adopted on 3/27/01 and were last amended on 8/29/06; however, they do not reference derivatives, leverage or shorting.
US Small Cap Managers
Artisan Partners does not use derivatives, leverage or shorting for this strategy. Artisan’s guidelines were adopted on 8/10/99 and last amended 8/29/06; however, they do not reference derivatives, leverage or shorting.
Washington Capital does not use derivatives, leverage or shorting for this strategy. Washington’s guidelines were adopted on 8/1/05 and last amended 4/29/08; however, they do not reference derivatives, leverage or shorting.
Developed International Managers
AQR (see above)
Barclays Global Investors (see above)
Use and Rationale: Capital Guardian uses currency forwards but does not employ leverage and shorting is limited to currency hedges. Currency forwards are used to manage currency exposure, provide liquidity, manage risk or implement strategies. Derivatives are not used to leverage the portfolio's assets.
Risk Management: The Investment Committee is ultimately responsible for risk exposure and monitoring guidelines. Capital Guardian uses vendor supplied software to monitor risk and some proprietary analysis. The Broker Review Committee is responsible for approving counterparties, although it doesn't appear that they have a separate set of guidelines specifically for derivatives counterparties. No discussion of collateralization.
Guidelines: Capital Guardian adopted their guidelines on 11/15/99. Currency hedging is permitted as part of a “defensive strategy” but there is no explicit reference to derivatives, leverage or shorting.
Reporting: Capital Guardian provides a appropriate level of detail in their reports, although it is buried within a large report (see “Portfolio Structure by Country and Currency”). This reporting is adequate if Capital Guardian is limiting derivatives positions to currency forwards, but it does not provide a breakdown of the country market value and percentage allocation into cash securities vs. derivatives.
Mercator Asset Management does not use derivatives, leverage or shorting for this strategy. Mercator’s guidelines were adopted 1/26/07. Currency hedging is permitted as part of a “defensive strategy” but there is no explicit reference to derivatives, leverage or shorting. Existing reporting is straightforward and the account statement is adequate if Mercator is not engaged in any currency hedging or other use of derivatives.
International Small Cap Managers
AXA Rosenberg does not use derivatives, leverage or shorting for this strategy. AXA’s guidelines were adopted on 8/1/05 and last amended 8/29/06. The guidelines state that currency hedging is permitted as part of a “defensive strategy” but there is no explicit reference to derivatives or shorting. Leverage is not allowed. Existing reporting is straightforward and the account statement is adequate if AXA is not engaged in any currency hedging or other use of derivatives.
GlobeFlex Capital does not use derivatives, leverage or shorting for this strategy. Guidelines were adopted on 7/28/05 and amended on 8/29/06 and state that currency hedging is permitted as part of a “defensive strategy” but there is no explicit reference to derivatives or shorting. Leverage is not allowed. Existing reporting is straightforward and the account statement is adequate if GlobeFlex is not engaged in any currency hedging or other use of derivatives.
Bernstein Investment Management does not use derivatives, leverage or shorting for this strategy. Bernstein’s current guidelines are dated January 2005. As a collective trust, there are no guidelines specific to OCERS. Subscription agreement contains virtually no restrictions as to the types of allowable securities or amount limits. Existing reporting is straightforward and the account statement is adequate if Bernstein is not engaged in any currency hedging or other use of derivatives.
William Blair does not use derivatives, leverage or shorting for this strategy, however, they are not restricted according to the fund’s prospectus. William Blair’s guidelines are dated 5/1/08. As a mutual fund, there are no guidelines specific to OCERS. The prospectus contains minimal restrictions as to the types of allowable securities or amount limits. Leverage is specifically allowed. Existing reporting is straightforward and the account statement is adequate if they are not engaged in any currency hedging or other use of derivatives.
US Fixed Income Managers
Aberdeen (see above)
Barclays Global Investors does not use derivatives, leverage or shorting for these strategies.
Loomis, Sayles does not use derivatives, leverage or shorting for this strategy. Loomis is able to, but does not engage in currency hedging for OCERS account.
PIMCO (see above)
International Fixed Income
Mondrian Investment Partners
Use and Rationale: Mondrian’s use of derivatives is limited to currency forwards. Derivatives are used for hedging purposes only. They do no use leverage and shorting is limited to currency hedges.
Risk Management: To reduce counterparty risk, Mondrian only enters into forward exchange contracts with what they consider to be high quality banks. Subject to competitive pricing, these contracts are usually undertaken with the client's custodian bank. Mondrian prices the forward contracts on a daily basis and monitors their value to ensure they do not exceed the value of the underlying assets.
Guidelines: Mondrian adopted OCERS guidelines on 12/12/90 and they were last amended on 8/29/06. Currency hedging is permitted as part of a “defensive strategy”. There is no explicit reference to derivatives, leverage or shorting.
Reporting: As long as derivatives are limited to currency hedging the existing report is adequate and is actually one of the better reports reviewed in terms of summarizing information.
Alternative Investment Managers
With the exception of PAAMCO, all Hedge Fund managers use some combination of derivatives, leverage and/or shorting; however, the risk processes in place are well thought out and documented and might be considered the benchmark for other managers. Unless the strategy is run as a separate account, guidelines will not be specific to OCERS.
Most private equity managers use derivatives/leverage/shorting but do not provide sufficient information to determine the level of risk being taken. Guidelines as to the type and extent of use are housed in the partnership agreements which are generally kept confidential.
Use and Rationale: Blackrock is permitted to obtain synthetic exposures through derivatives, although it is unclear if they are implementing the strategy at this time.
Risk Management: Blackrock does not engage in counterparty transactions at the fund of funds level, but they do monitor counterparty risk in underlying investment programs. They do not impose rigid credit and counterparty risk requirements or restrictions for the underlying private investments, however credit exposure and concentration is a general evaluation criteria.
Guidelines: As a commingled fund, there are no guidelines specific to OCERS. Those in place are dated 6/1/04 and state derivatives may be utilized at the fund of hedge funds (FoHF) level with no explicit restrictions or limits. Leverage may be utilized, up to 25% of NAV; the offering memorandum states that the credit facility is expected to be used for short-term liquidity purposes only.
Reporting: Blackrock provides a standard level of detail for a FoHF. The reporting is missing the amount of leverage, if any, that is being applied at the FoHF level. Given the potential use of derivatives to achieve synthetic exposures described in the PPM, a section disclosing these positions would be useful.
Bridgewater (see above)
PAAMCO does not use derivatives, leverage or shorting at the FoF level. As a commingled fund, there are no guidelines specific to OCERS. The fund guidelines make no reference to derivatives. Leverage (for investment purposes) and shorting are specifically prohibited.
The Clifton Group
Use and Rationale: The Clifton Group uses derivatives but they do not use leverage or shorting. The Clifton Group uses futures positions to overlay cash positions held at the fund level. Futures positions may also be held to maintain exposure during portfolio transitions.
Risk Management: The Clifton Group uses daily tracking reports to confirm compliance with guidelines or flag inconsistencies. All positions are held with a single clearing broker to reduce back office errors.
Reporting: Complete audits on the entire program are conducted twice per year.
Abbott does not use derivatives, leverage or shorting at the FoF level.
Adams Street uses leverage and shorting at times but they have not provided details. Adams Street reports provided excessive data (one of the quarterly reports is 1,140 pages long) so even if derivatives or leverage were being utilized at the FoF level it would be very difficult to determine how and to what extent they are being used.
HarbourVest uses derivatives periodically to hedge distributed stock positions as well as interest rate risk. Modest leverage is allowed, up to 10% but there is no shorting at the FoF level. HarbourVest does not provide standard exposure reports.
Mesirow does not use derivatives, leverage or shorting at the FoF level.
Schroders uses exchange traded commodity futures to gain exposure to individual commodities. They also use total return swaps linked to particular futures prices of individual commodities. All derivatives are used to obtain long-only exposure to commodities. Schroders does not use leverage or shorting.
Schroders uses Charles River Compliance to monitor investment guideline compliance. Their Group Agency Credit Risk team reviews counterparties and reports recommendations to the Group Credit Risk Committee for approval. Credit limits are established and reviewed annually or more often if necessary. Credit exposure is monitored daily with a maximum limit of 15% exposure with each counterparty. Derivative positions are fully collateralized.
Wellington has full discretion to use any type of derivatives but not leverage. Shorting of both derivatives and physical securities is allowed. Derivatives are used to achieve commodity market exposure, exchanges underlying bond market exposure, equitize cash, and make asset allocation shifts or hedge currency exposure. Most of the assets are held within several underlying internally-managed commingled funds and there is no look-through transparency. Although net exposure will not "typically" exceed 100%, gross long plus short exposure may be "significantly" higher than 100%. A Counterparty Review Group is responsible for establishing and reviewing criteria for Wellington counterparties. They maintain separate approved lists for Repos, OTC, and DVP counterparties.
John Hancock has the ability to use leverage up to 50% in PT2 (with no reference to leverage in PT3 guidelines) but does not currently use leverage. ForesTree IV guidelines allow borrowing for liquidity purposes but no additional detail is provided. They do not use derivatives or shorting.
RMK (Regions Bank) does not currently plan but does have the authority to use derivatives if needed to fund earnest money deposits (i.e., used as a bridge credit facility).
AEW Value Investors II and Core Property Trust may employ leverage up to 60% and 30%, respectively. Interest rate swaps are currently being used to hedge interest rate risk in Value Investors II (although the guidelines for both funds do not mention derivatives). The Guidelines (included in the RFI response, no offering documents were provided) do not specifically address derivatives, leverage or shorting. A sample report was requested but not provided.
American Realty Advisors may leverage up to 50% at the property-level and 40% at the portfolio-level but do not use derivatives or shorting. Reporting includes transparent information on leverage.
CB Richard Ellis/DA Management may use leverage up to 50% at the property-level and 40% at the portfolio-level but they do not use derivatives or shorting.
Fidelity may utilize leverage up to 70% at the portfolio-level with no stated limits on leverage at the property-level. In addition, interest rate caps and swaps may be used to reduce interest-rate risk related to property-level debt. The existing report is adequate, although the "Investment Structure" pie chart could be misinterpreted (i.e., that there is no debt on the underlying properties when in fact there is) and no information regarding potential derivatives use is provided.
LaSalle (Global REIT) LaSalle signed their guidelines with OCERS on 7/24/07 but they do not reference derivatives, leverage or shorting. Existing report is adequate.
SIS believes that OCERS should continue to allow the usage of derivatives. While our recommendations focus on improvement to the monitoring and reporting on their usage, some forward-looking planning should help to reduce the risk of surprise by the derivatives in the portfolio.
The OCERS Board, Staff and consultants and managers have participated in or concluded education programs on derivatives and their usage. The same statement applies to the inclusion in the asset mix policy of so-called alternative investments such as timber, hedge funds, and private equity. As the OCERS portfolio has become more diversified, it has also become more complex to monitor, a key point in Treasurer Streets’ memo. Sufficient staff resources must be allocated to balance the risk of investing in alternative strategies. Increased monitoring comes at a cost. Additional staff may have to be considered at a time when budgets are under pressure. Only the OCERS Board and Staff can determine if the current staffing can meet the additional monitoring recommendations from this study. SIS does not expect institutional investing to become less complex or risk management less demanding.
Below are specific recommendations staff can implement to mitigate unintended risks to the portfolio:
1. Based on our review of OCERS managers’ use of derivatives and the managers’ reporting of their derivative positions, it appears that the quarterly Staff report on derivatives exposure and leverage is missing significant derivative exposures, particularly with the Fixed Income, Commodities and Absolute Return managers. This is not to say that the derivatives exposure of the fund is not being monitored nor managed effectively. The managers that utilize derivatives as a significant part of their investment process on behalf of OCERS are among the most experienced and knowledgeable investment managers in the area of derivatives. They have the most robust risk management and counter party management systems, guidelines and techniques in the industry. So, while we might suggest improvements in monitoring and reporting, generally it is to facilitate understanding and communication to OCERS, OCERS staff and interested constituents and not due to a concern that the investment strategies which use derivatives are taking on inordinate risk through their use.
2. Ensure that both the market value and notional exposures are provided for all derivatives positions. Be more explicit in manager guidelines/contracts on the definition and usage of derivatives. In cases where managers don’t regularly use them but do occasionally, determine a reasonable maximum and specify the allowable instruments with the usual caveat that the manager can request exceptions with justifications.
3. Develop exposure reporting templates for each asset class/sub-class and have each manager submit information accordingly so that a) derivatives & leverage can be monitored on the same basis, b) information is available in an easy to understand summary format and c) exposures by manager can be aggregated.
4. As part of their standard reporting package, require managers that use derivatives extensively (e.g., PIMCO) to provide a plain-language description of their largest positions, why they are in place and what risk(s) they represent.
5. Define leverage consistently across all managers whenever feasible and ensure that managers’ reports clearly differentiate between financial leverage and effective leverage.
6. There is no consistency or standard in place for pricing OTC derivatives. In many cases the pricing is done by the manager which creates a potential conflict of interest. Write manager investment guidelines that incorporate the policies and procedures used to value the underlying investments, including valuation methodologies, sources and inputs, and key assumptions.
7. There is no consistency or standard used for assuming counterparty risk (concentration and quality). The level of due diligence varies by manager but OCERS may want to have clear guidelines when it comes to their manager’s counterparties or specifically state that the manager is responsible for counterparty analysis and risk management. Determine if/how derivatives positions are collateralized; if they are supposed to be fully collateralized and how is this verified? This is particularly important when managers are using over-the-country swaps and derivatives.
8. OCERS Board and Staff and consultants know their managers well enough to discern whether our individual manager comments should result in revision of manager guidelines/contract/reporting documents. In many cases, particularly the fund-of-funds, commingled funds and limited partnerships, only the reporting can be influenced and even then only by exception depending on OCERS’ representation in the asset pool.
9. Of the four primary building blocks of derivative contracts (futures, forwards, options, swaps), credit default swaps are the riskiest in terms of the kind of counterparty risk that we have stated, the unwritten laws of unintended consequences that can come from unmodeled financial instability of the previously unprecedented type the world is currently experiencing. Numerous OCERS managers use credit default swaps in the implementation of their various investment strategies. Such managers require more risk monitoring and transparency requirements in the reporting of their usage.
OCERS has written investment policy for the total fund and the various asset classes. Implementation of the Reed Smith study further improves the governance structure and oversight of the fund. Risk cannot be eliminated from OCERS Fund and still have any possibility of meeting the long-term benefit payments. Even with all the attention being paid to derivative risk, there will always be individual contract risk. Investment managers employ a multitude of ways to evaluate the risks and rewards of implementing strategies through the use of derivatives. Many managers do not use them to implement their particular investment philosophy and strategy. Those that do will argue for their usage due to their flexibility in modifying the portfolio characteristics or exploiting market inefficiencies, their low cost and their liquidity. The managers will attempt to use them carefully but they all have certain risks and not all those risks can be controlled. The risks of derivatives can only be eliminated by explicit exclusion of their usage and that would diminish the efficiency of the OCERS Fund and increase its overall cost. The manager lineup would have to be completely restructured and only a few competitive institutional bond managers would be able to invest OCERS’ assets. OCERS’ performance versus its peers would also be disadvantaged. In summary, the overall use of derivatives by OCERS’ managers is reducing the risk and the cost of the portfolio.
One of the purposes of investment policy is to define an acceptable level of market risk for each plan, at the total fund, asset class, and portfolio levels. As long term institutional investors, we accept this risk, which we can define as Endogenous Risk, or systematic risk. This is risk that must be accepted in order to gain returns above the risk-free rate (which has been close to zero for several years in Japan and which has reached that level in the US during the recent financial crisis). Conversely, Exogenous Risk can be defined as idiosyncratic or diversifiable risk that results from plan sponsors having the flexibility to make short-term tactical asset allocation decisions or to allow investment managers to employ active management in an effort to generate above market returns. Finally, Exotic Risk, most prominently leverage, is that taken when the market is full of optimism and people stop being investors and start becoming speculators.
While we continue to believe Endogenous, or Market Risk, is necessary for plan sponsors to achieve their long-term return expectations, we strongly believe OCERS should reevaluate the Exogenous and Exotic Risks. Not that risk should necessarily be reduced or eliminated in all areas; in fact, there are certain opportunities to achieve returns that come about only once in a generation or, perhaps, once in a lifetime. However, it will take time for the global financial system to stabilize as it continues to de-lever in light of a new economic reality and for market participants to regain trust in each other. Risks that were accepted with a different economic and investment outlook should be reevaluated based upon a distinctly different future. OCERA should consider asking the following questions: What are the risks that we took when the future looked bright? Those are the risks that need to be evaluated and decide whether they should be maintained.
Background on derivatives
Completely understanding derivative securities is a somewhat impossible task in the complex financial system that has operated up until recently. A common definition is that derivatives constitute a contract between two parties that is linked to interest rates, currency exchange rates or regularly traded indexes. The contract links its owner to the risks and rewards of a financial instrument without actually holding the underlying asset. Derivatives are used by banks, brokers, businesses and investors to hedge risks, make a market, or to speculate. These contracts facilitate the pricing, the transfer of and the acceptance of risk. Risk of price or interest rate movement is transferred (hedged) and risk is accepted (investor speculator, hedger) based upon underlying data or the value of a market. The contract is a two-party agreement that specifies the obligated payouts.
To gain an understanding of how derivatives are used in the management of OCERS’ pension fund, we will answer four questions:
1. What are the derivative contracts being used by OCERS’ managers?
2. How do investment managers use derivatives to implement strategy?
3. What are the risks involved in the use of derivatives?
4. What procedures is OCERS following to manage derivatives risk and is the current oversight adequate to mitigate financial shock?
There are four basic types of derivative contracts: futures, forwards, options and swaps.
A variety of derivative contracts can be created by combining these basic building blocks. These arrangements can be quite complicated so understanding the concepts behind basic derivatives and why companies/investors use them is necessary to “accept” controlled use of these financial instruments in OCERS’ fund. Again, the primary use of these instruments is to reduce risk for one party while offering the potential of reward at higher risk to another. Since there is a very diverse range of potential underlying assets and payoff alternatives in today’s financial marketplace, derivatives offer a multitude of opportunities for an investor to either hedge or speculate at a cost that is significantly lower than owning the asset or shifting the portfolio strategy through buying and selling the physical securities or assets.
A majority of OCERS’ investment managers are using derivatives within their portfolios to hedge existing risks, to influence the duration of the holdings, and to enhance returns. Private equity funds, real estate managers, and many hedge funds employ leverage to enhance returns, to influence balance sheet structure, to leverage equity deployment and to hedge risks. Banks and brokers act as intermediaries facilitating the process for a fee and to collect and maintain margin from the borrower.
Simply stated, a forward contract is an agreement to buy and sell a specific quantity of a particular asset at a pre-agreed price and to become due at a specific future date. For example, a company that sells frozen foods contracts with a vegetable grower to buy a given quantity and quality of corn at a specific price with delivery to be made shortly after harvest. Agreements of this nature have been used for centuries to protect both the buyer and the seller of commodities from the risks of movements in prices. The farmer intends to eventually sell his crop after the harvest. If today’s price for corn covers his cost of production plus an acceptable profit, he minimizes his risk from future price fluctuation by entering into a forward contract. The frozen food company that accepts the contract knows that it is assured of receiving the corn and the cost of the raw material needed to in turn produce their product. This activity in forward contracts also applies to futures contracts, the next discussion; however, there are some very important differences.
The most prevalent use of forward contracts in today’s financial market is in the currency and interest rate market. In a forward contract, just about any willing buyer and seller can agree to trade in anything in any amount to be delivered and paid for at any specified date. While this allows parties a great deal of flexibility, they still have to find each other and, most importantly, trust each other to honor the contract. Intermediaries such as banks and brokers act to fill this need. When the intermediary agrees to underwrite the transaction, then each party is able to trust the trade as long as they trust the bank/broker. This explains why banks, in particular, are such active participants in forward exchange markets.
In a forward transaction, no cash is exchanged upfront. Consequently, counterparty risk can accumulate over the life of the contract. Since no cash changes hands at the onset of the agreement, the counterparty risk is limited to the marked-to-market profit of the contract rather than the notional value.
Collateral in the form of cash or marketable securities is often required to be provided by one party as a performance guarantee. If the collateral is securities, the owner continues to earn dividends or interest on the securities. If the price of the collateral declines, the holder will usually ask for more securities. Should the collateral be cash, it is invested by the counterparty.
The term “futures” refers to an exchange traded forward contract. Futures contracts commit the holder to take or make delivery of a specific commodity or financial instrument at a fixed future date for an agreed upon price. Futures contracts are very standardized with the underlying financial or physical asset being closely defined. The contracts specify certain minimum quality, quantity, and the delivery date normally on a fixed cycle such as March, June, September and December. Most futures contracts, especially financial, are not held to maturity.
The holder can close out the contract by entering into an equal or opposite transaction. An important difference between futures and forward contracts is that futures contracts are marked to market at the close of each trading day. A purchaser of a futures contract will have to make an upfront cash payment known as initial margin. The initial margin depends upon your role as hedger, speculator or public customer. Futures contracts are traded on an exchange and individuals execute trades on the exchange through a futures broker. The exchange holds the initial margin and the buyer will have to provide additional collateral whenever the daily price reduces the value of the collateral below the initial margin level, a margin call. Profits above the minimum margin may be withdrawn daily or simply accumulate until the position is closed. Since no interest is paid on the margin, US Treasury Bills are frequently used as margin. The Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), Kansas City Board of Trade (KC) and the New York Mercantile Exchange (NYM) are all well known organizations that exist to facilitate futures trading.
The major differences between forwards and futures are summarized below:
Type of Transactions
Traded on an exchange
Forward price agreed upon at the start
Statement price on delivery date
Profit or Loss
Realized at time of settlement
Realized in cash daily
None until delivery
Daily margin requirements and period margin calls
Underlying bond or cash
Cheapest to deliver bond or cash
While forward and futures contracts offer the holder a choice but not the obligation to buy or sell a specified underlying asset on or prior to a particular date, a call option offers the buyer the right to buy a specified underlying asset such as a stock. A put option does the opposite by giving owner the right to sell the stock. The call or put option price is a notional amount termed the call price or put price. Since the right to buy or sell is valuable the buyers or sellers have to pay for it. A premium will also usually exist reflecting the perceived time value of money to expiration and will be heavily influenced by investor psychology. In strong advancing markets the premium on calls will increase just as in weak markets the premium in puts rises.
Numerous standard term options are traded on exchanges worldwide. Others trade in over-the-counter markets and are often governed by less standard terms. Options are structured for stocks, bonds, ETFs, indices, and commodities. All options are worthless at expiration unless they are “in the money,” where it may make sense to exercise it or the option for a profit. A call or put that is “in the money” can be exercised, taking possession of the asset with a market value settlement, paid with cash. You then can hold on to the asset or sell it for a profit and pocket the excess option premium. Options are a very low-cost way of participating in the various fluctuations of a very wide array of assets. The biggest appeal is their variety of uses to hedge, earn premium income, speculate, gain market exposure and all at a normal price relative to the underlying asset. Your maximum risk of loss is the dollar cost of the original purchase. Option pricing theory is quite mathematically challenging. The most widely known theory is based upon the Black Schoeles formula. Active institutional users of options and futures use various models to identify mispricings and payoff schemes that generally guide them in usage.
Broadly speaking, a swap is a legally binding agreement to exchange a series of cash flows based upon the value of, or the return from, a single asset with a series of cash flows based upon a second asset. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest rate swaps involve the exchange of one set of interest payments for another set of interest payments all in the same currency. Interest rate swaps have been used in the United States since the early 1980s to facilitate the management of interest rate risk. Swaps of this nature specify (1) the interest rate on the payments being exchanged; (2) the type of payment, such as fixed or variable; (3) the notional principal which is the total value on which the interest is being paid; and (4) the time period over which the exchanges will continue to be made. Swaps can be quite complex and as long as the two parties perceive a need, can agree on terms and trust each other to deliver, there will be a swap market.
Swap and forward contracts have a very important disadvantage, counterparty risk. Since each agreement requires the exchange of a payment, the contract is subject to each party’s ability to pay and to do so at a specific date. If no margin or collateral has been required, a default by either party will result in an unsecured loss with little recourse. Investment managers who are active users of swaps and forwards maintain credit research staffs and counterparty risk committees to hopefully mitigate this risk. The bankruptcy of Lehman Brothers is the most obvious recent example of how counterparty risk can be misjudged. Lehman Brothers will be remembered for many years to come as creditors attempt to recoup losses due to its failure.
This year’s financial markets turmoil has been complicated by a derivative called credit default swap. Technically speaking, all corporate bonds contain counterparty risk since the corporation may fail, be restructured or default on the payments. The investment world refers to this as credit risk. This risk is measured by how the company’s bonds trade relative to US Treasury securities of comparable maturities. Bonds of similar rating such as AA and maturity will be priced similarly though not identically depending upon current or expected business success of each individual company within the AA rated sector. When US economic growth slows or declines, corporate bond spreads will widen, increasing the comparable interest cost to a corporation borrowing funds in the public markets. Never missing an opportunity to fill a need in the investment world, Wall Street created a credit default swap so investors could hedge the risk of a corporation (credit) deafulting .
Investors expect to be paid for or hedged against the different risks that are involved in managing against an unknown future, with an often known liability. US Treasury bills offer investors a risk-free rate of return. Higher interest rates from corporate bonds come from a combination of the risk-free rate, yield curve risks, systematic risk premiums in the market and a premium for the risk of default. Just as interest rate derivatives facilitate the transfer of interest rate risk between counterparties, credit default swaps allow for the efficient transfer of issue-specific credit risk from one party to another. The buyer of protection pays a periodic premium to the seller (assuming the risk for a fee) for the right to sell back the bond at par in the case of default. Once again, no cash exchanges hands upfront. Portfolio managers use credit default swaps to reduce or even remove corporate risk or if a seller, is the equivalent to buying corporate bonds. Thus credit default swaps offer the flexibility to adjust corporate credit exposure less expensively and more efficiently than buying or selling specific bonds.
The protection seller has counterparty risk if the payer is unable to make premium payments. Conversely, the buyer expects the seller to buy the bonds at par in case of a credit event/default. Some fiduciaries consider credit defaults to be a form of leverage since there is no upfront cash outlay. An important risk of credit default swaps is liquidity, unlike the interest rate swap market which is quite liquid. To fill this need, organizations such as the Institutional Index Company, the CDS Index Company and Markit Group Limited have created credit default indexes. These companies poll investment banks to determine the credit entities that a credit default index will be constituted upon. The specific index has standardized terms, are liquid and, therefore, less expensive than over-the-counter swaps and are worldwide in coverage. The most popular index series are referred to as CDX and iTraxx. These indexes allow investment managers great flexibility in reducing or taking advantage of spread risk. Extensive use of quantitative models are employed in valuing and managing credit default risk. Counterparty risk always remains and AIG was an aggressive seller of protection. The high risk of a global recession and concurrent increase of default risk has placed them in a very challenging position as evidenced by the recent infusions of cash and equity into the firm by the US Treasury.
The overselling of protection against default that AIG engaged in has generated much writing and discussion by public officials whether credit default swaps play a role in creating or magnifying the current global financial upheaval. Both users and opponents of these risk transfer agreements agree that investor confidence would be improved by some amount of transparency and counterparty risk reduction. We do not expect an outright ban on their usage. We do not expect to see recommendations coming from FASB, the SEC and various derivatives associations, and possibly from Congress.