More pension funds seek derivatives

By Natsuko Waki

LONDON (Reuters) - Pension funds that use derivatives are faring better during the credit crisis because they mitigate and hedge risks, and interest in using options is set to increase, State Street's fund arm said on Wednesday.

The credit crunch of the past eight months has emphasised the importance of valuation and risk management for pension funds, which are keen to adopt greater 'alpha-seeking' investment strategies via tactics such as long/short equity instead of relying on 'beta' methods of simply tracking a benchmark.

And the use of derivatives helps pension funds manage and hedge their investment risks, according to Joe Moody, head of liability driven investing at State Street Global Advisors.

"In the credit crisis, schemes which embraced derivatives faced the test. I suspect ones that adopted derivatives fared much better," Moody told a briefing on Wednesday to present a report on the pension funds industry.

"There is a huge interest in the use of over-the-counter derivatives. Derivatives are not just about increasing risks but they are seen as risk mitigation and useful for hedging."

Moody said derivatives such as swaps and swaptions for interest rates and inflation hedging and equity call options are set to garner more interest, adding that these options were different from complex instruments such as collateralised debt obligations (CDO).

CDOs, complex bonds that pool securities to boost yield and in theory spread risk, helped fuel the U.S. mortgage lending boom by providing a source of demand for risky mortgages, which were repackaged and sold to investors across the globe.

As more of the risky mortgages began to default last year, rating agencies downgraded hundreds of billions of dollars of CDOs, forcing some into technical default.