Our default position for the Reference Portfolio is to access market exposures by funding our global passive managers. In implementing our Actual Portfolio, however, we make judicious use of derivatives, when it is efficient and cost-effective to do so. These decisions are made on a case-by-case basis.
Considerations include the funding costs of instruments like forwards and swaps which provide the market exposure we desire, the expected returns on the pool of collateral we are required to deposit to gain this exposure, and the ease and efficiency with which a derivative contract aids in the rebalancing of our portfolio. We also evaluate the use of derivatives against our own internal operational capacities and whether derivatives provide the best use of our internal risk limits for the use of counterparties (e.g. banks).
What are derivatives?
Derivatives are financial instruments that replicate the behaviour and performance of certain types of investments. Typically, they are linked to:
- individual securities such as equities
- indexes on bonds and equities, such as New Zealand’s NZX50, which aggregate the performance of a group of securities
- reference rates (such as an exchange rates or interest rates).
Why use derivatives?
There are many types of derivatives and many reasons to use them, including:
- to manage risk and liquidity
- to lower transaction costs
- as added-value investments in their own right
- as different ways of getting the same investment exposure (for example, instead of owning all of the thousands of shares in the MSCI World index, we can agree with a bank that they will pay us the index return as if we held those shares, and we will pay them the funding cost of holding those equities).
We use derivatves as an access point for either completing the portfolio (i.e. to achieve the required market exposures of the Reference Portfolio), for adding or reducing the Fund risk, and for implementing investment opportunities.
Managing currency risk
The benchmark currency hedging decision for the Fund is set by the Reference Portfolio. Currency derivatives, such as forward contracts, allow us to manage any foreign currency risk in an efficient manner.
Managing portfolio risk
In addition, the actual portfolio tends to “drift” away from its target exposures through time due to differential performance of the various asset classes we own and also due to changes in exchange rates. In other words, the portfolio’s actual risk can drift away from the desired risk. Derivatives are a convenient way of re-balancing the portfolio back to its targeted risk level.
Derivatives can also help us to manage our liquidity. When we enter into a derivative contract, we often are not required to make any deposit against this exposure. Where we are required to set aside a deposit, it is often a relatively small percentage of the underlying exposure. This means we hold a pool of collateral within the Fund, while maintaining the desired market exposures through the derivative. In instances where we require liquidity at short notice, closing the derivative position allows us to access an immediate source of cash.
Reducing transaction costs
Derivatives can lower transaction costs because:
- index derivatives are often cheaper to buy than the individual physical securities making up the index
- commissions are generally negligible.
The default position for the Reference Portfolio is to access market exposures by physically funding passive managers. We only deviate from this in the Fund's Actual Portfolio after determining that the net cost of the derivative is lower than the cost of obtaining the market exposure passively, with all relevant risks priced in and considered. Use of derivatives introduces risks that are not present when we use passive managers. These risks include counterparty risk, liquidity risk and operational risk. We maintain robust processes to measure, manage and report on these risks.