Afores to the fore

Mexican pension funds have doubled their use of structured products and derivatives this year. Jayne Jung looks at the changes in regulation and risk management techniques among the top funds that are driving this trend

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There are signs that Mexican pension funds, or Afores, are journeying towards a new frontier. The funds, which controlled about 810 billion pesos ($75 billion) at of the end of September, have sharply increased their use of structured products and derivatives. Derivatives use leapt from 15.2 billion pesos in December 2006 to 28.2 billion pesos in September, an increase of 86%, according to the Comision Nacional del Sistema de Ahorro Para el Retiro (Consar), the Afores' regulator. In September 2006, that figure was 14.1 billion pesos.

The surge comes on the back of several key changes in regulation. In November 2005, legislation was passed to allow Afores to hold foreign equity exposures through exchange-traded funds (ETFs), while in July this year, a rule was passed that will allow automatic salary deductions from those workers that have not elected for a specific pension provider to be allocated to those Afores with the highest returns, as opposed to those with the lowest fee. The rule will come into effect from March 2008, and in preparation some Afores are turning to derivatives and structured products to bolster their returns.

The new regulations are in response to a desire for Afores to increase returns and modify their risk/reward profiles. "The regulations have been adapted because we saw the possibility for Afores to manage new instruments, while keeping operational, market, liquidity and credit risks controlled," says Luis Mario Hernandez Acevado, general director of planning and financial regulation at Consar in Mexico City. Over recent years, the regulator has performed simulations of efficient frontiers (which describe the risk/reward characteristics of optimal portfolios) and value-at-risk behaviour of different portfolio asset allocations, and the impact of regulatory changes that relax investment constraints on these. Their results showed that the kinds of regulatory changes that it has - and is planning to - roll out will have a net positive effect on portfolio risk/reward characteristics.

And derivatives and structured products use looks set to increase further as VAR limits are eased. Under legislation passed in July, each pension fund will be required to increase the number of sub-funds after the first quarter of 2008. Currently, Afores are structured into two funds: one for contributors 56 years and older and one for contributors younger than 56, with VAR limits of 0.6% and 1.0%, respectively. By March 2008, there will be five sub-funds: 26 years and younger; 27-36 years; 37-45 years; 46-55 years; and 56 years and over. The corresponding VAR limits will be 2.0%, 1.6%, 1.3%, 1.0% and 0.6%. In making these changes, Consar it taking its cue from the Chilean pension system (see box). The change in VAR limits will enable pension funds to take higher levels of risk for younger contributors - potentially through structured products.

Alejandro Echegorri, Monterrey-based chief investment officer at Afore Principal, part of Des Moines, Iowa-based Principal Financial Group, believes that a true risk management culture is now finally developing. "About three years ago, we saw some Afores use derivatives, but we didn't see an increase in performance. We saw an increase in volatility without a correlation to returns," he explains. "The truth of the matter is that the industry has been learning recently. We are seeing more skilled portfolio managers, risk management systems are now in place and people have a better understanding of how to play derivatives - how to open and close positions and how to hedge positions."

Before November 2005, pension funds were only allowed to invest in domestic and foreign equity markets through principal-protected structured notes linked to equity indexes. Since then, the rules have been relaxed to allow Afores to invest in single-stock baskets so long as they replicate an index, equity indexes through options and futures, and ETFs that replicate an index. In June, the rules were changed again so that capital protection is no longer necessary.

Under Consar regulations, there is an overall 20% combined limit on investments in both equity and fixed-income foreign securities, and a 15% limit on equity exposures. The average foreign equity exposure among Afores during the 12-month period ending on August 31 was 12%. Given their transparency and stock-like characteristics, ETFs have become the most common vehicle through which Afores gain equity market exposures.

As of mid-October, Afore BBVA Bancomer, the second-largest pension fund in Mexico, with $12 billion of assets under management, had around 15% of its portfolio invested in foreign equities, with about 90% of that amount through ETFs. "We trade ETFs daily and most of the trades are done in New York for cost reasons," says Enrique Garduno, Lomas de Chapultepec-based director of investments at Bancomer.

BNP Paribas, meanwhile, claims some of the largest Afores have expressed interest in equity structured products to gain exposure to foreign markets. "For example, they might be concerned that China will lose its momentum, the market might go down and they'll lose investors' money. Through the use of principal-protected notes, they know that if the market moves against them they'll preserve the principal," says Francisco Hervella, New York-based head of Latin American structured product solutions at BNP Paribas.

One structure that has been garnering some interest among Afores is a five-year principal-protected note linked to a basket of global indexes comprising the S&P 500, Euro Stoxx 50 and Nikkei 225 indexes. The pension fund receives the principal plus any positive performance of the basket at maturity.

Elsewhere, Societe Generale Corporate and Investment Banking (SG CIB) is taking a different approach towards Afores and is therefore seeing a slightly different demand. Samuel Rosenberg, head of equity derivatives sales for the Americas at SG CIB in New York, says his firm's effort to differentiate itself from others courting Afores business is to offer new types of indexes, such as so-called intelligent indexes - that is, products that use discretionary or quantitative models to outperform traditional indexes. According to Rosenburg, innovation is especially important because of the strong competition for business posed by some other banks that are affiliated with particular Afores, such as Mexico City-based Banamex, which is owned by Citigroup.

SG CIB is currently attempting to obtain regulatory approval on a product that references the Brazilian, Russian, Indian and Chinese (Bric) markets. The note is linked to the bank's SG Vol Target Bric index, which aims to outperform the S&P Bric 40 Total Return Index by exploiting a relationship between bear markets and rising volatility in Bric markets to achieve the optimal allocation between the S&P Bric index and one-month dollar Libor. If the volatility of the S&P Bric 40 Total Return Index decreases below a pre-defined target, the SG index automatically increases its exposure to emerging markets and reduces its exposure to Libor. If the volatility of the S&P Bric index increases above a pre-defined targeted, then the opposite occurs. SG CIB says its Mexican pension clients are showing strong interest in it.

Away from equities, dealers say Afores' changing portfolio composition is also manifest in fixed income, where moves into longer-dated products that better match liabilities are under way. "A few years ago, Mexico pension funds were investing in very short-term securities where the average maturities were less than a year. The long-term view from the pension funds on the asset side has taken time to develop despite the fact their liabilities are very long term," explains Raul Martinez-Ostos, Mexico City-based head of debt capital markets and client coverage for Mexico at Deutsche Bank. However, as the regulatory changes have taken place, Afores have gradually increased the average duration of their portfolios. Currently, most of the Afores' assets have an average life of five years of less, while liabilities typically range from 10 to 30 years.

Thanks to a provision passed by Consar in August, Afores now have wider access to longer-dated fixed-income assets in the form of domestic real estate investment trusts (Reits) and other structured products tied to public works projects. Although no such trades have been executed as of October, Principal's Echegorri believes structured products referencing real estate and public works projects will become popular, given the potentially higher returns on offer. "Mexico needs to invest a lot in infrastructure. So, you have both demand and supply here," he explains.

While most of the Afores welcome regulatory moves that are opening up a wider universe of investments to them, some analysts question whether the regulator's apparent preference for Afores to use structured products is wise. An assessment of the Mexican derivatives market, released by the World Bank and the International Monetary Fund (IMF) in May 2007, notes that pension funds could achieve the same kind of risk/reward profile offered by their purchase of principal-protected structures more cheaply through the direct use of index options and other derivatives.

Currently, just a single pension fund, Banamex, has met the 31 requirements set by Mexico's central bank and Consar that permit Afores to trade all permissible types of derivative: futures, forward contracts, swaps and options, with local and non-local counterparties. Under the requirements, Afores that want to achieve this kind of trading freedom require straight-through processing, and must demonstrate that their portfolio managers understand and can manage risk associated with different kinds of instrument.

This certification process helps regulators to control operational risks, while the use of VAR limits helps constrain market risk among Afores, says Consar's Hernandez Acevado, who believes that many pension funds are unwilling to make the requisite investments in infrastructure, people and technology to become authorised to use derivatives to the same extent as Banamex. "If they want equity exposure, they don't need derivatives. They can use ETFs. If they want exposure to interest rates, they can do that through the stock markets indirectly. But everyone knows that derivatives provide them with flexibility. For large Afores, these are good tools to move fast between one position and another," he says.

Chile wind of change

Chile is widely considered to have one of the most progressive pension systems in Latin America, if not the world, and this year legislators have allowed pension funds to invest in hedge fund-linked derivatives. Although no such transactions have been completed, the sub-funds established for the youngest pensioners have large exposures to high-performing, higher-risk markets. As of June, 78.6% of these funds' total assets were invested in equities. The average annualised returns for these funds as of June was 18.02%, according to the pension trade group Asociacion Gremial de Administradores de Fondos de Pensiones.

By way of an example of Chilean pension funds' sophistication, one dealer says that earlier this year, a fund executed a $50 million three-year call option based on the performance of a basket of three indexes of equity markets in China, India and eastern Europe. Overall, Chilean pension funds have an average of 55% of their assets allocated to equities, with an average return of about 11% over the 12 months ending in September.

The three largest pension funds in Chile - Provida, Cuprum and Habitat - control around 72.5% of total pension fund assets, according to Francisco Hervella, New York-based head of Latin American structured product solutions for BNP Paribas.

Chilean legislators are currently debating whether or not to lower barriers to entry for pension fund management to foster greater competition. "We believe that our pension funds have become a bit complacent, so we are introducing legislation that increases competition," says Andres Velasco, Chile's finance minister.

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