Derivatives - power tools for pension funds.

• Author: McCord, James H.

Derivatives are quickly becoming the instruments of choice for pension funds that want to strategically manipulate their risks. But you must choose your weapon carefully.

Derivatives, once labeled a mere adjunct to stocks and bonds, are fast becoming standard operating procedure for many U.S. pension funds. Derivative use is growing rapidly because these instruments have powerful and broad consequences for portfolio management. They actually permit the plan sponsor to manipulate the shape of the expected return distribution.

Plan sponsors have long invested in a broad range of asset classes to create returns that best offset the range of liabilities they face. In general, earning better returns required either changing the asset-distribution mix or hiring and firing managers. With either method, the return distribution was generally symmetric, at least with traditional securities classes. But with some help from derivatives, managers and sponsors can remove, truncate, emphasize or control risks both tactically and strategically.

For newcomers to the field, a derivatives instrument is a bilateral contract or payments-exchange agreement whose value is measured by the value of one or more underlying instruments, reference points or markets. The term covers a broad range of instruments ranging from options, futures and forwards to customized swaps and combination instruments, such as collars and structured notes. Many investment managers use derivatives to hedge on option overriding programs or to time the buying and selling of securities to keep fully invested. In addition, some managers and sponsors trade bond and index futures to change or rebalance portfolio weightings before buying the underlying securities. However, as plan sponsors increasingly use derivatives directly, the real growth will be in the over-the-counter derivatives markets.

That's because derivatives possess several important attractions for pension-fund sponsors. Once you overcome the initial policy and procedural hurdles, they provide faster and cheaper ways to implement strategies. For example, you can buy a structured note to get into a foreign or international market without hiring a consultant, a global custodian or an expensive investment manager.

In addition, derivatives also let sponsors fine-tune their results or hedge out undesirable aspects of the manager's performance. That's an important plus, because hiring and firing managers can be a very expensive way to...