When are higher derivatives used?

The bad in the good - derivatives in endowment funds

Many foundations distrust derivatives, but in the future they will (have to) be used not only as hedging instruments, but also as sources of return. A classification.

From Elmar Peine

Derivatives don't have the best reputation. In the context of exchanges, many associate them with immoral speculative attacks, hidden costs, and great risks. Especially in the value-oriented foundation sector and especially in a phase in which the (supposed) effects of capital investments are increasingly being considered with sustainability, the use of derivatives is not an issue that fund companies and their managers peddle. Even if the futures, options or certificates are used to improve the portfolio structure or to reduce risks and fluctuations or to limit maximum losses, it is better to keep quiet as long as there is no conscious inquiry. One fears the prejudices of the customers.

A few weeks ago we conducted a small survey of the fund managers of the 52 endowment funds we recommended. Unfortunately only 28 houses took part. Only five fund managers consider derivatives to be of no importance. This includes Commerzbank (endowment fund Yield E), Kroos Vermögensverwaltung (endowment fund Westphalia) or Frank Wettlauffer (smart and fair fund). Achim Lange (Hamburger Stiftungsfonds) is also one of those purists for whom derivatives (in the long term) are rather expensive accessories. If they are used for security, so the arguments of the skeptics, the vehicles cost returns. It is better to let the funds fluctuate a little more and to be fully involved in the good market phases right from the start.

Proponents of the use of derivatives argue that they can not only be used simply and very quickly to incorporate security lines and loss limiters into the asset structure without undesirable side effects. Derivatives can also be used to finely control the desired exposure in foreign currencies, the interest rate structure of the bonds, the equity risk and other properties of the portfolio. The DWS Stiftungsfonds, for example, buys derivatives “for controlling equity exposure, pension exposure, duration control and currency management (...). The market movement in March 2020 showed us that the use of CDS (credit default insurance - E.P.) was important to limit risks, ”says DWS man Markus Diebel in beautiful fund manager German.

Allianz, for which derivatives are also "very important", uses index futures for its endowment fund for sustainable purposes. Likewise, Invesco's fund for foundations. Like the Pax-Bank and Salytic, the GLS is cautious about its climate fund, according to its own statements. You only "occasionally" use options and futures or other forward transactions for hedging.

Bernhard Matthes, manager of the BKC-Treuhand portfolio, uses “Equity Index Futures to vary the target equity quota so that you don't have to touch the physical inventory. It is about transaction costs and the receipt of the dividend contribution in the event of a decrease in the share quota. "That means, if the BKC fears falling prices, you" bet "on it with a derivative in order to compensate for the losses of your own ( physical) stocks. The BKC could also sell parts of its stock portfolio, but this would incur transaction costs and the prices of the shares would also be pushed down by the sales (market impact), which would reduce the proceeds. And if it is then bought back, the costs and disadvantages arise again.

One thing is clear: protection against higher losses is still the predominant motivation for using derivatives in fund management, especially for foundations. Two approaches come into play: Either you “bet” (with futures) that the prices will fall and receive a loss-reducing item if the prices actually fall. If the prices rise, however, such a "bet" reduces the profit. Or: With a put option, you buy the opportunity to sell shares at a fixed price. If the prices fall significantly by the cut-off date, you can “exercise” the option in order to sell at a better price than the current one. With one option, funds are insured against unwanted price fluctuations. These derivatives are used in particular in the custody accounts of professional investors, who often have to adhere to very narrow risk parameters.

In particular, options allow funds but also other possibilities, because instead of buying an option and thus assuming the role of the policyholder, a fund can also sell options and thus become an insurance policy. The fund insures other market participants against unwanted price fluctuations via an option and collects a premium for this. If the "insured event" occurs, however, greater losses can occur if the fund has "leaned too far out the window" or has not reinsured.

At the latest, when derivatives are used to increase returns, terms like casino capitalism and the like are often used to insinuate that the principle “left pocket right pocket” applies here, i.e. profits on one side cause losses on the other, so no systematic source of return is available. However, this cannot be sustained with a view to the option transactions. Systematically speaking, the sale of options for a premium, i.e. the insurance business, is the production of the scarce commodity security, for which the wealthy pay a premium that goes beyond the risk equalization. It is very clear: the premium is a systematic source of return. The importance it can have is shown by specialized funds such as the Optoflex from Feri, which generates comparatively high and constant (ordinary) income and meanwhile has assets of over 1.5 billion euros.

For more and more managers of endowment funds, the profit-making motive when using derivatives is playing a role.

Extrapolated, around a quarter of the foundation funds should also or even exclusively use derivatives to generate returns. With the Kepler Ethik Mix Balanced, one wants to “do more than just hedge” with derivatives, says Gernot Hauzenberger, one of the fund managers. Wave AG made a similar statement for Hannoversche Mediuminvest. Guido Barthels from TBF Global wants to "earn money with our use of derivatives ..."

Stefan Rädler from Deutsche Oppenheim, Germany's largest family office, is even more specific: “At FOS Yield and Sustainability, derivatives are used primarily in the portfolio context. This concerns both the hedging of risks (interest rate, currency and market risks), but also the opportunistic use of options, especially depending on the volatility. This can serve the preparation of the acquisition as well as the pure generation of bonuses. "

Deka even specifies a return target for the use of derivatives in its two foundation funds (Deka-Institutionell Stiftungen I; Deka Stiftungen Balance). The derivative activities in both funds should bring a return of 0.5 percent per year.

The Berlin fund manager Andreas Heinrich (HuH Stiftungsfonds) is more ambitious. He is aiming for a return contribution of around one percent per month through the purchase of options. He has described his approach exclusively for Renditewerk (to the article).

The Flossbach von Storch Foundation defensive SI uses a similar strategy for the return-oriented use of derivatives like Heinrich. The vehicle, which has been named Foundation Fund of the Year by RenditeWerk several times, shows a convincing performance and has beaten its benchmark index three times in the past five years alone. Fund manager Elmar Peters sells call and put options, that is, he insures against rising and falling prices, foregoing returns in stormy up and down markets, but instead collects the extra points that make the difference in "normal" stock market times .

Some endowment fund managers are now also looking to return on futures. The Selection Rendite plus of the Munich boutique Selection uses a squirrel model, with which parts of the book income are continuously realized (also through futures), with futures also helping. The fund manager Jörg Scholl, formerly founding managing director of Hauck and Aufhäuser Asset Management and DWS fund manager, as well as his colleague Claus Weber RenditeWerk have revealed how this works (read the article).

Derivatives are very flexible and they tie up little capital. Since the transactions relate to the future, the funds only have to offer collateral (margin) in order to be able to pay in case of doubt. If call options (e.g. on BASF shares) are sold that are matched by (BASF) shares in the portfolio, almost no capital is tied up for the options. Even with put options, only a small part has to be held as margin. This means that the return from the derivative commitment always comes on top, it does not replace or displace other sources of return such as dividends or rents.

The trend of recent years and the acceptance in the foundation sector clearly show that the premium source of income is becoming more important. This is supported on the one hand by the low interest rates and the demand for alternatives. On the other hand, statutory planks ensure that investors do not have to fear any shocks. The most commonly used (UCITS) guideline limits the speculative use of derivatives to twice the market risk, which means that an equity fund may only buy or sell twice the value of the existing equity portfolio per forward.