Derivatives have come a long way and are now extensively used by the fund management industry.

But if not used carefully they can bring illustrious banks to their knees or severely impact the earnings of companies, so every multinational needs to keep a very careful eye on this area and have a firm policy in place. It is important to remember that two groups will be critically affected if things go wrong and if large losses are incurred. The first group, of course, is the multinational itself which, in the case of salary related (DB) pension funds, takes on the ultimate investment risk and so could be required to increase contributions to the local fund to maintain (often legal) minimum coverage. But, in my experience, it is the second group which often does not involve itself sufficiently in this question that also could be seriously affected: the local trust fund/foundation board.

It is worth reiterating that in many countries this local, legally constituted, fiduciary body has both the responsibilities as well as the liability - often at a personal level! It is therefore in its interests to have a clear policy on the use of derivatives in the fund. The starting point should be at the local pension fund level where a series of simple, sequential questions need to be answered, in order, before any derivative activity is considered. These are:

q does the board understand the proposed derivative?

q does the board understand all the risks associated with the proposed derivative?

q is the board satisfied that local staff understands both the proposed derivative as well as its risks?

q is the board satisfied that the local organisation has an adequate monitoring and control system to manage these risks?

q where derivatives are to be used by one of the external fund managers, is the board satisfied that the manager understands the product, its risks and has adequate risk management systems in place?

These are some crucial early questions to ask before a fund should even be allowed to consider particular derivatives. As the CEO of a large international fund manager told me recently: I don't allow derivatives in any of our equity portfolios as the markets we use are liquid and I don't want to use valuable management time worrying about monitoring and controlling the associated risks."

Now that is food for thought!

Nevill Brooke is an adviser to international pension schemes"

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