Pension funds, property derivatives, and risk

Implications: Pension funds are embracing a new opportunity in property derivatives. 

First, managers of pension funds must be careful to understand the derivative, its underlying asset, and the impact on the return/risk of the pension fund's portfolio. 

Second, managers of pension funds can not focus on enhancing returns through speculation.  They must use such instruments to manage risk (hedge).

  

Analysis: Susan Mangiero does a very good job reviewing the evolving market for property derivatives.  This market, as Susan notes, is in its infancy and will grow in the future.

The question is whether property derivatives is a good investment for pension funds.  A case can be made for and against pension funds investing in property derivatives.  However the ultimate question comes down to a source and use of funds issue.  The source of money for pension funds assumes a rather low risk profile (i.e., employees).  Pension fund managers must appreciate this fact.  Although desiring to maximize return, pension fund managers must first look at risk.  Derivatives can be used to enhance return through speculation, or mange risk through hedging, diversification, etc.  I propose managers of pension funds should focus on risk management before enhanced returns.

Real estate is an attractive investment for pension funds.  Thus real estate derivatives can likewise be attractive.  However this does not eliminate answering the following questions:
1.    What is the default and counter party risk related the derivative?
2.    What is the true volatility imbedded in the derivative?
3.    How does such an investment affect the overall volatility of the pension portfolio?

In summary, pension fund managers cannot be swayed by the potential returns from property derivatives.  They must first focus on the risk inherent in property derivatives, and the use of such instruments to manage the overall risk of the pension portfolio.