Derivatives costly and ineffective: Research

The majority of superannuation pension products eschew derivative strategies due to high costs and lack of effectiveness, latest research shows.

Only one-third (37%) of superannuation funds in Milliman's latest survey are using derivatives to protect retirees against market downturns.

Milliman head of fund advisory services Michael Armitage said more than half (53%) of super funds believe the cost of using derivatives for downside risk management and tail-risk hedging was too high.

"Fees can have a compounding impact on long-term returns. However, the real question is whether they provide a greater benefit than their cost. This can only be judged through the prism of members' goals, which is shaped by super's underlying purpose," he said.

While downside protection always has a cost, futures-based dynamic risk management overlays avoid the higher cost of implied volatility embedded within option pricing, Armitage said.

For example, with the ability to create custom synthetic option strategies over lower-risk diversified portfolios (as opposed to purchasing high-cost equity options), funds are learning downside protection may be cheaper than traditional option purchase protection strategies, he said.

In an environment where volatility is particularly low and markets steadily rise over an extended period, the value of risk management strategies is not as apparent.

"The median balanced super fund has posted eight consecutive financial years of positive returns since the global financial crisis. Investment returns in six of those years have been no lower than 8.7% as central banks around the world have flooded markets with liquidity, pumping up asset prices.

However, market cycles continue and funds should carefully consider the needs, goals and behaviour of their entire member base through good and bad times, he added.

Last month, a separate Milliman survey found superannuation funds were increasingly using derivatives to combat sequencing risk as the demand for more retirement-focused products grows.

Four-in-five super funds (79%) are frequently using derivatives for risk management and hedging strategies, particularly for rebalancing portfolios and assisting with fund manager transitions.

The most popular methods include overlay structures (65%), external manager mandates (47%) and asset allocation core components (26%).

Read more: DerivativesSuperannuationMillimanMichael Armitage
Link to something nggQPXO9