With Nick Leeson serving his six-and-a-half year sentence in a Singapore jail and the catalogue of derivatives disasters continuing to grow, the investment community is taking a long, hard look at derivatives trading. Some of the mistrust of these instruments is attributable to a continued lack of understanding of their mechanics and of the positive role they serve within companies’ treasury departments. And IROs have to bear some of the responsibility for that lack of understanding.
Investor relations officers in companies which routinely use such instruments should be prepared to answer the detailed questions which analysts and shareholders should, and will, be asking them. Indeed, they should be prepared to raise and explain these issues themselves, rather than waiting for the queries to arise.
In particular, shareholders need reassurance that the risk management tools being employed by companies are not more risky than the underlying market risk they purport to control. Assuming that is the case, an IRO’s explanation should make investors feel more comfortable about the way the business is being run, not just less uncomfortable.
So what are derivatives? The report by the Washington Group of Thirty on derivatives practices and principles defines a derivative transaction as ‘a bilateral contract or payments exchange agreement whose value derives from the value of an underlying asset or underlying reference rate or index.’
In other words, it’s a gamble on whether a specific price will go up or down over a given period. The price in question might be an interest rate, an exchange rate, the price of a commodity or the price of an equity.
Derivative transactions can be structured as futures, forwards, swaps or options, or any simple or complex combination thereof. They can be undertaken on a regulated exchange or directly with a counterparty over-the-counter. Derivatives are tools for managing risk, but can only be as effective as those using them.
It is important for IROs to explain clearly why their company is involved in derivatives activity in the first place. Is the objective to hedge against an adverse price movement or is the aim to exploit specialist price knowledge to add revenue – that is, to speculate? Shareholders may have very different views on each of these objectives depending on their own motivation for investing in a particular share.
John Rooney, oil analyst at Standard Life in Edinburgh, explains his approach to oil sector stocks: ‘I am looking first of all at the whole sector in the light of the main variables, which are the commodity price and the exchange rate,’ he explains. ‘For individual stocks other factors, such as reserve replacement and exploration discoveries, have to be considered. But in terms of risk exposure, my decision to invest depends on how I, as an analyst, am viewing those main variables. If the company is gearing itself up on a bullish price view which I do not share, I would perceive that company as a financial risk.’
In such circumstances investors may well be reassured by a policy of hedging against downside oil price risk and could regard failure to do so as a form of speculation.
Liz Butler of London stockbrokers Panmure Gordon agrees. ‘Hedging downside risk is prudent management,’ she says. ‘It’s like an insurance policy.’ Butler compares this to taking out environmental insurance, which costs the company money but is clearly a sensible thing to do. Indeed, for an oil or chemical company, the need for insurance against an environmental disaster is self-evident – something no analyst or investor would quibble about. Insurance against a price disaster can be regarded in the same light.
But hedging, by its nature, can result in loss of upside as well as downside. But, according to Butler, ‘It doesn’t tend to come out like that. It’s just that the average price realised by the company tends to be a bit low.’ However, Butler concedes that shareholders do want to have their cake and eat it: they want to have the downside protection but without giving away any of the upside. And that objective can only be achieved by purchasing options which, in isolation, can be prohibitively expensive in a volatile market.
Others have found that such impossible restrictions can be overcome by informing shareholders of their derivatives philosophy and having them buy into it up-front.
Donald Ingham, treasurer of Air Canada in Quebec, notes that his company is in a cyclical business. ‘Our shareholders love it when we can eliminate some of their risk and that’s what hedging does,’ he says. ‘From that point of view we have their full support. There is so much volatility in the price of jet fuel, which is about 15 per cent of our costs, that any little bit of quiet in the storm is appreciated.’
As for the loss of upside: ‘We have educated our shareholders that there is a cost to perfect knowledge,’ says Ingham. In short, they are prepared in advance for the opportunity cost of foregoing the windfall of a drop in jet fuel prices which has been hedged away. ‘We do not have as much support on foreign exchange hedging where we have a natural hedge because a proportion of our revenues are in the currencies in which we pay our expenses. Even on interest rates we have a natural hedge, because we have about C$1 bn invested.’
Shareholders have a realistic attitude to risk if the IRO provides the necessary information. They must understand what the company is trying to do and the possible consequences of a risk management policy. Without such information, it is natural to suspect that derivatives activity is speculative and therefore more difficult to justify.
Following the disasters at Daiwa, Orange County, Barings and so on, some investors are becoming more wary, or having second thoughts, about using derivatives. Ingham again: ‘Shareholders increasingly want assurances that the activity is not out of hand. We have a well publicised hedging policy on which we report to management every week. We involve three or four people with detailed knowledge of what is going on so that parameters cannot be exceeded.’
Without information on corporate derivatives philosophy, institutional investors may not only fail to perceive derivatives risk but may also be robbed of the very exposure – to a commodity price movement, for example – which was their prime reason for investing in the stock in the first place.
Take the oil sector, for example. Analysts and shareholders expect oil companies to hedge their exposure to interest rates or currencies. But many institutions invest in oil shares, particularly exploration and production company shares, precisely because they want exposure to oil price fluctuations. For them a policy of rigorous dollar oil price hedging would deny them such exposure and defeat the purpose of holding the stock. ‘In those circumstances you would not see shareholder disappointment directly,’ explains one London oil analyst. ‘What you might see is the stock gradually trading at a discount to its peer group because it didn’t offer such good gearing to a particular commodity price or a particular variable.’
But Standard Life’s Rooney counters this. ‘If a stock is regarded as a commodity price play, the fact that the company may have hedged against downside does not enter into (its share price movements). This is the difference between theory and practice.’
A review of commodity price versus share price correlation confirms this apparent contradiction between shareholders’ express motivation for holding a stock as a proxy for commodity price exposure and the results such stocks are able to deliver. An analysis of the average share price of the UK’s two largest oil exploration and production stocks compared with the dollar and the sterling oil price since the beginning of 1991, shows that for long periods the correlation is weak.
Shareholders investing in these stocks to gain oil price exposure over the period from the beginning of 1991 to end-November 1995 would have enjoyed a correlation of less than 0.35 in sterling terms and around 0.50 in dollar terms. In the short term, such as during the land war in the Gulf when the dollar oil price/share price correlation rose to 0.75, or during the UK’s withdrawal from the ERM when the sterling oil price/share price correlation rose to 0.96, the correlation can be better. But over long periods oil stocks have been a less than satisfactory proxy for the oil price.
It would be logical to expect institutions craving commodity price exposure to invest directly in commodities themselves. So should IROs in companies in sectors with high exposure to commodity prices be concerned that their unexplained use of derivatives markets might scare some risk averse shareholders off? And might the derivatives markets themselves prove an attractive alternative for those shareholders who relish commodity price risk?
In practice, these issues are complicated. Institutions are often restricted from taking the direct approach by the conservatism of trustees. According to Rooney, ‘Direct commodity involvement is perceived as more highly speculative than investment in quoted oil stocks. It would be very difficult to get trustee approval for direct investment.’
But that’s not always the case. In its Survey of UK Pension Funds conducted in 1994, Buchanan Partners found that 57 per cent of those questioned were already using some form of derivatives, although the most commonly stated motivation was for tactical asset allocation rather than for enhanced performance. In fact the survey’s findings were that, ‘Very few funds are restricted in their use of derivatives by trustees.’
In 1995 the European Managed Futures Association (EMFA) together with Intersec Research Corporation published a survey entitled Institutional Use of Structured Derivatives and Derivatives in 13 Countries.’ They found that 61 per cent of European pension funds and insurance companies used derivatives directly or via their external fund managers. But the results again confirmed that this was primarily for asset allocation, currency hedging or for taking positions on interest rates, rather than as an alternative to buying ordinary equity stocks in expectation of a better result.
That begs the question of why institutional investors wanting commodity price exposure prefer to invest in equities rather than derivatives, when they clearly have the capability to use the latter. Jane Martin, executive director of the Managed Futures Association (MFA) in California, offers one possible explanation: ‘In the US derivatives have received a very bad press and since managed futures are one subset of the derivatives market, we too have suffered.’
Martin cites the example of the Virginia Retirement Service(VRS), the state pension system for public employees in Virginia, which began investing in managed futures in 1991 only to withdraw again in 1994. At the peak of its involvement, VRS had $460 mn invested in managed futures. ‘VRS had very good performance, but things like Orange County, Barings, etc all came into play,’ says Martin. ‘If you buy IBM stock and it goes down, nobody says you’re stupid.’ Not so with investment in derivatives.
Bill Sullivan of VRS’s public relations office agrees that derivatives scandals haven’t helped, but he says this is not the whole story. ‘In any pension fund the board takes an oath to act as fiduciaries. The General Assembly takes an active interest in how VRS is investing members’ money. Derivatives and managed futures in particular were seen as an inappropriate investment for a public pension fund.’
Sullivan says that the problem, and the ultimate reason for withdrawing, was that the performance was oversold to the board by outside advisers and some of its own board members. ‘It was claimed that the Service could expect returns in the 20 per cent range, but the net return over the investment period was in the 5-6 per cent range,’ he says. ‘We are now getting returns from the equity market of around 25 per cent with very low fees because we are dealing with billions of dollars. Managed futures fees compared with the equity market are high.’
Disenchantment with managed futures, however, does not tempt VRS to cut out the middle man and invest in the futures exchanges on its own behalf. This is seen as a labour intensive activity requiring specialist knowledge. But in pulling out of the market, the board of VRS adopted a resolution to encourage its investment staff ‘to continue to search for ways to include futures trading within the investment programme when the potential to help VRS to meet or exceed its investment objective is present.’
In practice this has been translated into a willingness to allow outside managers employed by the fund to use the derivatives markets and to stand or fall by their results. For his part, Bill Sullivan’s final word on the VRS foray into derivatives is: ‘If I were to design a way not to sell a market, boy, this one has really done it.’
Nevertheless the question about continued investment in equities versus derivatives remains. Perhaps it can be best explained by a consideration of benchmarking. According to one pension fund manager: ‘If you are measuring yourself against the FT All Share Index or the S&P 500, all you are looking for is to outperform against that. If you invest in the stocks in the index you will be close to your benchmark and it doesn’t really matter what those stocks do.’
This attitude is confirmed by the Buchanan survey which found that pension funds ‘continue to judge performance as a comparative rather than an absolute figure. The commitment to medians may be one reason for the limited interest in non-traditional investment management techniques.’
Such conservatism may give some reassurance to IROs that their institutional shareholders are not about to desert them in favour of the derivatives markets, but there is no room for complacency. Despite the Leeson legacy, derivatives have gained a toe-hold in the minds of institutional investors. And the very least IROs can do is to publicise their own company’s derivatives strategy and demonstrate that the activity is competently managed and adequately policed.
Otherwise they risk losing their shareholders either to those companies in their own sector who can give such assurances with confidence – or even to the derivatives market itself.
