Synthetic equities see interest as schemes look for creative ways to derisk

Schemes such as Surrey County Council Pension Fund are considering synthetic equities as they look to lock in improvements in funding levels due to recent growth asset outperformance.

Simeon Willis, principal consultant at consultancy KPMG, said the use of synthetic equities, such as options and futures, has risen as these instruments allow schemes to achieve better matching of liabilities while retaining exposure to growth assets.

A more traditional approach would be to retain equity exposure and hedge with inflation derivatives, which meant that collateral would need to be held elsewhere.

“[Now] instead of holding physical growth assets you hold physical cash and gilts but you can also have more illiquid bonds in the portfolio which gives you extra yield,” he said, adding derivatives can be put in place to get extra growth asset exposure.

“By flipping it around, all the growth exposure can be backed by the collateral sitting behind it, so you don’t need to use different bits of your portfolio as collateral,” he said.

Some schemes are switching to the strategy “wholesale”, he added, while others use it in markets where they feel passive management is best.

Harris Gorre, head of financial products at Investec Bank, said it has seen investors selling equities to lock in gains from strong equity markets and synthetic exposure.

“The major strategy for that cash at the moment is [liability-driven investment] type mandates, which are leveraged swaps to get inflation exposure, and to get some yield they will go buy corporate credit.”

Mark Stanley, senior portfolio manager at asset manager Payden & Rygel, said schemes need to be certain about what they are trying to hedge.

“It is not as easy as you might think to buy protection on the MSCI World,” he said. “It is pretty straightforward to buy it on the S&P, FTSE and the Euro Stoxx. To get paid a close match to what you own in your portfolio isn’t as easy as you might think.”

The use of these strategies also depends on the sponsor. Robin Creswell, managing principal at the asset manager, said: “A sponsor that’s in pretty good financial health could potentially have the flexibility to make additional contributions [and] if needed might take a more creative, more interesting approach to the problem.”