Flying high with derivatives can be risky

Derivatives are like aircraft: In the right hands, they are wonderful vehicles, but in the wrong hands, or incompetently handled, they are dangerous.
As David Hoffman reported in last week’s issue, derivatives have made their way into mutual funds, and most mutual fund investors are totally unaware of that fact.
Even financial planners and investment advisers can’t easily determine the extent to which derivatives are used in mutual fund portfolios — let alone how they are used.
They also can’t determine how experienced the fund portfolio managers are in using derivatives.
This means that mutual fund investors and their advisers are flying blind and could be headed for rough weather without any warning.
Of course, the word “derivative” covers a multitude of investment vehicles and strategies. It includes relatively common put and call options, and stock and bond index futures, but also more exotic instruments such as swaps and swaptions, collateralized mortgage obligations, total-return and credit default swaps, and commodity derivatives.
Protecting against loss
Most derivatives can be used to protect against loss or to enhance returns modestly with limited risk.
Buying put options for a portfolio can protect it against market declines, generally at modest cost. Selling call options on the stocks in a portfolio can enhance its return when the market is moving sideways.
Stock and bond index futures also can be used to hedge portfolios or to put to work instantly new cash flow without affecting the market prices of the stocks being acquired.
But these and other instruments can be used in more dangerous ways. Futures can be used to leverage portfolios, for example.
Leverage can greatly enhance returns when times are good, but it can magnify losses when markets move the wrong way. Just ask the investors in Greenwich, Conn.-based Long-Term Capital Management LP, a hedge fund that blew up in 1998.
CMOs promise high returns, but high returns rarely come without high risk. Ditto credit default swaps and some of the other exotic derivatives.
All can be useful to enhance the returns of mutual fund portfolios if used judiciously — that is, if the exposure is kept to a safe level, and the portfolios are diversified to minimize the risk level.
But used carelessly by inexperienced portfolio managers or by portfolio managers stretching for higher returns, they can bring disaster to investors.
There is no way, at present, for investors to make reasoned decisions about whether to accept the exposure to derivatives, and no easy way for their financial advisers to get the information needed to advise their clients properly. Beta, the most common measure of market risk, the one most commonly reported by mutual fund monitoring services, generally doesn’t reflect derivatives use.
Mutual fund companies must be more forthcoming in their prospectuses and their reports on their use of derivatives: the maximum levels of exposure to derivatives they allow in each portfolio, which kinds of derivatives they allow in those portfolios, what they use the derivatives for — e.g., enhancing returns, transporting alpha, hedging, etc. — and the derivatives-trading experience of the portfolio managers who use them.
Mutual fund trackers such as Lipper Inc. in New York and Morningstar Inc. in Chicago must ferret out that information and make it available to their customers.
Planners, advisers and their clients shouldn’t be left in the dark as to the true level of risk they are taking when they invest in their choice of mutual funds.
Before the fund watchers begin to gather and publish this information, many planners and advisers will have to refresh their knowledge of derivatives, a technical area
the details of which are all too easy to forget when not dealt with
frequently.
Then they will be equipped to educate their clients and help them make appropriate choices of funds, fully cognizant of what the derivatives in their funds bring to the table in terms of risk and return.
Until then, mutual fund investors are flying blind in foggy weather, and as use of derivatives increases, the weather gets foggier.