NATIONAL SUPERANNUATION FUND POLICY ON THE USE OF DERIVATIVES This is Version 3.0

Transcription

1 NATIONAL SUPERANNUATION FUND POLICY ON THE USE OF DERIVATIVES 2017 This is Version 3.0 To be reviewed on November 2017

2 DOCUMENT CONTROL Document Owner Name David Brown Position Chief Investment Officer Change Record Version Author Date Change 1.0 Dominic Beange 23-Jun-15 Create Strategy 2.0 David Brown 25-Oct-16 Update Strategy 3.0 David Brown 28-Aug-17 Update Strategy Approval Name Investment Committee Meeting No. 39 Board Meeting No. 101 Publication Evidence Minutes of Committee Meeting of 6-Spet-17 Minutes of Board Meeting 21-Sept-17 Site Evidence Annual Report Included in Annual Report for 2016 Public section of NASFUND web site Uploaded to web site on June 2016 Submission of Investment Strategy to BPNG Version: Not required to be submitted Date submitted: 3-Jan-17 Page 2 of 12

3 Table of Contents 1. PURPOSE OF THE INVESTMENT STRATEGY The purpose of this policy The objective of this policy LEGISLATIVE REQUIREMENTS The primary legislative document The Trustee Board Prudential Standard 1 / RESPONSIBILITIES AND ACCOUNTABILITY The ultimate responsibility The Licensed Trustee DEFINITION OF A DERIVATIVE WHY USE DERIVATIVES? AUTHORIZED USE OF DERIVATIVES RISK MANAGEMENT REVIEW OF THIS POLICY Page 3 of 12

4 1. PURPOSE OF THE INVESTMENT STRATEGY 1.1 The purpose of this policy is to provide the guiding principles for the use and oversight of derivatives in management of the Fund s investment assets. 1.2 The objective of this policy is to provide a framework for use and control of derivatives and to ensure the Fund has effective operational, risk management and compliance controls when using derivatives. 2. LEGISLATIVE REQUIREMENTS 2.1 The primary legislative document governing the superannuation industry is the Superannuation Act 2000 (as amended). 2.2 The Trustee Board is also required to adhere to various Prudential Standards and in relation to the use of derivatives> The Superannuation Prudential Standard 1/2014 Authorised Superannuation Fund Investments (PS 1/2014). Paragraph 34 (a h) refers in detail. 2.3 Prudential Standard 1 / 2014, Paragraph 34 (e) states that Trustee Board must develop, document, and maintain a Policy on the use of Derivatives, in consultation with the Licensed Investment Manager, and include the policy as part of the Investment Framework. 2.4 Prudential Standard 1 / 2014, Paragraph 34 (f) states that Trustee Board in consultation with the Licensed Investment Manager, must develop, document, and maintain an appropriate risk management framework to capture, measure, monitor and manage the potential risks of any derivatives positions taken directly or indirectly. The risk management system must be sophisticated enough to measure risks on an aggregate basis. 2.5 Prudential Standard 1 / 2014, Paragraph 34 (h) states that The Policy on the Use of Derivatives must be published in the Annual Report to members and be published in the public section of each ASF s web site. Page 4 of 12

5 3. RESPONSIBILITIES AND ACCOUNTABILITY 3.1 The ultimate responsibility for the sound and prudent investment of members funds rests with the trustee Board. 3.2 The Licensed Trustee has a written Investment Framework governing the selection, management and monitoring of investments risks and ensures the Trustee Board, and all those (internal and external) responsible for implementation of the Framework and the Investment Strategy act with a high degree of integrity and for the benefit of members. 3.3 This Policy on the Use of Derivatives forms part of the totality of systems, structures, policies, processes and people to address the Trustee Board s responsibilities with regard to investments of the Fund. 3.4 This Policy should be read in conjunction with the Investment Framework, and the Risk Management Framework. 3.5 The Trustee Board in consultation with the Licensed Investment Manager, has developed a risk management framework to capture, measure, monitor and manage the potential risks of any derivatives positions taken directly or indirectly. 3.6 The Investment Division and the Licensed Investment Manager are tasked with the on-going monitoring of the investment portfolio, including derivatives, if any. The Investment Committee is tasked with regular review of the investment portfolio, including derivatives, if any, and the IC reports to the Trustee Board as part of that regular review. 4. DEFINITION OF A DERIVATIVE 4.1 A derivative is a financial instrument whose value depends on, or is derived from, the value of some other underlying asset, including but not limited to interest rate, currency rate or a variety of indices. 4.2 Generally there are five main categories of derivatives identified by the assets from which they are derived: Page 5 of 12

6 4.2.1 Equity derivatives; Currency derivatives; Interest rate derivatives; Credit derivatives; and Commodity derivatives. 4.3 Common types of derivatives include futures contracts, forward contracts, options and swaps, each with its own regulatory, risk and documentation requirements. 4.4 Derivatives can be traded through exchanges or privately traded over the counter (OTC). 5. WHY USE DERIVATIVES? 5.1 Derivatives are commonly used to improve the risk/return profile of an investment portfolio and to improve the chances of the portfolio meeting its objectives. 5.2 Derivatives can facilitate the management of investment risks and/or provide an efficient means of implementing various market exposures and investment strategies Common uses of derivatives include the following: Derivatives can be used to hedge or control investment risks, such as using forward foreign exchange contracts to hedge currency risks Derivatives can be used to gain access to investment exposures that are otherwise unavailable (for example, to international equities when it is not possible to buy the underlying equities due to shortages of foreign currency, or because the market is not open to PNG investors) Derivatives can be used to gain quick access to the economic exposure to a market, before the cash is gathered to invest in the underlying investments. Once the cash is gathered, the derivative can be reversed as the underlying investments are purchased Derivatives can be used to gain economic exposure to certain international asset classes, and yet avoid currency risks which arise when PNG Kina is Page 6 of 12

7 converted to foreign currency and used to invest in the underlying investments Derivatives can be used to implement investment strategies in a low cost and efficient manner Derivatives can be used to create leveraged positions Derivatives can be used to create economic exposures to a wider set of investment opportunities than might be available the Fund s home market, or within the Fund s regular investment universe. 6. AUTHORIZED USE OF DERIVATIVES 6.1 Paragraph 34 (b) of PS 1 / 2014 establishes responsibilities on members of the Trustee Board (see below 6.3.2). Accordingly, The Trustee Board will set a very high requirement for disclosure and understanding before approving the use of any derivatives. 6.2 The Fund s Trust Deed permits the use of derivatives. Section 9.2 (g) of the Trust Deed refers. 6.3 That said, the Trustee Board will only permit the use of derivatives subject to certain guiding principles. These are as follows: 6.4 The Licensed Trustee and the Licensed Investment Manager will ensure that the assets and liabilities of the Fund will not include a derivative, except where allowed under Paragraph 34 (b) to (e) of Prudential Standard 1 / See PS 1 / 2014 paragraph 34 (a). 6.5 The Trustee Board will ensure that at any time the assets and liabilities of the Fund will not include a derivative unless each Director of the Trustee Board fully understands and is able to explain the potential risks of any derivatives positions taken directly or indirectly. See PS 1 / 2014 paragraph 34 (b). 6.6 Derivatives will only be used to reduce the risk of existing investments or currency positions. See PS 1 / 2014 paragraph 34 (c). Page 7 of 12

8 6.7 Derivatives may only be used when the exposure is fully covered by the assets of the Fund. PS 1 / 2014 paragraph 34 (d). 6.8 Derivatives will not be used to obtain exposure that is substantially different from that which could be obtained through physical securities, nor will derivatives be used to create market exposures, net of derivatives, that fall outside designated ranges. 6.9 The use of any derivatives would specifically consider liquidity management as part of the consideration in using any derivative It is possible that some collective investment vehicles, such as mutual funds, in which the Fund invests may themselves allow derivatives, for other than purely hedging purposes. The Investment Division and the Licensed Investment Manager are required to address the issue of embedded derivatives in such investment vehicles as part of the consideration of any new investment. If such investments are deemed to breach the guiding principles on the use of derivatives, in literal interpretation or in the spirit of these principles, then the Fund will not invest in such an investment. 7. RISK MANAGEMENT 7.1 There are various risks associated with the use of derivatives. The following subsections detail the key risks and the relevant controls by which the Fund assesses, monitors and manages these risks. 7.2 Market Risk, including Basis Risk: Market risk represents the risk of adverse movements in markets for the derivative or the underlying asset, reference rate or index to which the derivative relates. Such a risk is created by holding a security, physical or derivative, which creates exposure to movements in prices of a security or market In particular, derivatives give rise to Basis Risk: the risk that the price of the derivative security does not move in line with the underlying security Market Risk is managed through ensuring: Page 8 of 12

9 Sufficient diversification is maintained across asset classes, regions, sectors, securities and investment managers. Regular monitoring of effective market exposures, net of derivative positions, to ensure all exposures fall within designated ranges; The Fund is not geared and adequate liquid assets are maintained to meet all potential obligations arising from physical and derivative positions; and Basis Risk is considered when hedging or adjusting the Fund s asset exposure, especially when derivatives form a part of the implementation of the Investment Strategy. 7.3 Liquidity Risk There are two forms of liquidity risk with respect to derivatives: The risk that the fund will not be able to unwind its positions at or near the market price due to lack of market depth; and The risk that the Fund is not able to meet its cash flow obligations such as margin calls on futures contracts (which would be in a currency other than PNG Kina) Liquidity Risk is managed through ensuring: The liquidity risk of any derivative is considered prior to its use; Agreements with external investment managers will be scrutinized for derivatives use before appointing external investment managers, to ensure compliance with this policy; and The fund will maintain sufficient liquid assets to back derivative exposures at all times, and ensure this by setting up the required accounts to deal with margin calls. 7.4 Counterparty Risk. Page 9 of 12

10 7.4.1 Counterparty Risk is the risk that the counterparty (being the other party to the derivative contract) will not honour (in whole or in part) their contractual obligations Exchange traded derivatives (like futures contracts) are traded through clearing houses, which significantly reduce Counterparty Risk by requiring collateral or margin deposits Over-the-counter (OTC) derivatives are traded on a bilateral basis between the Fund and one particular counterparty, such as a forward foreign exchange contract with a bank Counterparty Risk is managed through ensuring: All exchange-traded derivatives must be cleared through a recognized exchange (eg: Sydney Futures Exchange); OTC derivatives will only be contemplated with undoubted counterparties OTC derivatives will only be contemplated if executed under industrystandard agreements, such as International Swaps and Derivatives Association master agreements (ISDA s) (or equivalent); Where practicable, the Fund will seek to negotiate netting agreements so that payables and receivables are offset to determine net exposures with counterparties. 7.5 Operational Risk is the risk of financial loss due to inadequate or failed internal processes, people, systems or external events Operational Risk is managed through ensuring: Separation of duties between the Investment Division and the Finance Division, the latter of which settles transactions on which the former make recommendations and may have delegated decision-making authority. Page 10 of 12

11 Strong involvement of the Licensed Investment Manager (LIM) in the process of choosing whether or not to use a derivative, and in the reporting of exposures through the LIM monitoring responsibilities in the written agreement with the LIM The Fund s Risk Management Framework is implemented in full, including ensuring compliance with procedures and controls is monitored by management on a regular basis and reported to the Trustee Board. 7.6 Currency Risk is the risk of financial loss due to adverse changes in exchange rates Exposure to offshore assets may improve the risk/return profile of the Fund s investments, by exposure to assets with less correlation to PNG assets than the alternative, and through exposure to a wider investment universe The Trustee Board recognizes that currency risk is multi-faceted Currency Risk is managed through ensuring: Adequate diversification is maintained at the aggregate level; Any derivatives used to manage currency risk will be limited to shorter terms rather than longer terms, to manage the risk of a major loss in any one period Derivatives will not be used to create/increase currency risk. 7.7 Interest Rate Risk is the risk of financial loss due to adverse changes in interest rate sensitive instruments Fund assets most likely to be at risk of loss due to interest rate changes are long-dated fixed income securities such as Government Inscribed Stock (GIS) issued by the State of PNG, and possibly other issuers in the future GIS interest rates are vulnerable to significant changes in line with supply and demand pressures, such as when the State of PNG is financing a budget deficit The Trustee Board recognises that in periods of high GIS supply that interest rates may rise (significantly) but that such periods also offer the opportunity Page 11 of 12

12 to acquire GIS in significant volume. Thus, acquisition may be in line with investment strategy for the medium term, despite the risk that acquisition may incur revaluation losses in the current period Interest Rate Risk is managed through ensuring: Adequate diversification is maintained at the aggregate level by limiting the amount to be invested in GIS and other fixed income securities Seeking to increase trading in fixed income securities among PNG institutions, in order to be able to manage interest rate risk through secondary market trading Limiting the average length of maturity of the fixed income portfolio to prudent limits, including offshore fixed income At the time of writing, there are no interest rate derivatives available to directly hedge PNG interest rate risk. 8. REVIEW OF THIS POLICY 8.1 This Policy on the Use of Derivatives will be reviewed regularly by the Licensed Investment Manager and the Trustee Board, and such a review will be done at least annually. Page 12 of 12