Flying high with derivatives can be risky

APR 30, 2007
By  ewilliams
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.

Latest News

SEC charges Chicago-based investment adviser with overbilling clients more than $2.5M in fees
SEC charges Chicago-based investment adviser with overbilling clients more than $2.5M in fees

Eliseo Prisno, a former Merrill advisor, allegedly collected unapproved fees from Filipino clients by secretly accessing their accounts at two separate brokerages.

Apella Wealth comes to Washington with Independence Wealth Advisors
Apella Wealth comes to Washington with Independence Wealth Advisors

The Harford, Connecticut-based RIA is expanding into a new market in the mid-Atlantic region while crossing another billion-dollar milestone.

Citi's Sieg sees rich clients pivoting from US to UK
Citi's Sieg sees rich clients pivoting from US to UK

The Wall Street giant's global wealth head says affluent clients are shifting away from America amid growing fallout from President Donald Trump's hardline politics.

US employment report reactions: Overall better than expected, but concerns with underlying data
US employment report reactions: Overall better than expected, but concerns with underlying data

Chief economists, advisors, and chief investment officers share their reactions to the June US employment report.

Creative Planning's Peter Mallouk slams 'offensive' congressional stock trading
Creative Planning's Peter Mallouk slams 'offensive' congressional stock trading

"This shouldn’t be hard to ban, but neither party will do it. So offensive to the people they serve," RIA titan Peter Mallouk said in a post that referenced Nancy Pelosi's reported stock gains.

SPONSORED How advisors can build for high-net-worth complexity

Orion's Tom Wilson on delivering coordinated, high-touch service in a world where returns alone no longer set you apart.

SPONSORED RILAs bring stability, growth during volatile markets

Barely a decade old, registered index-linked annuities have quickly surged in popularity, thanks to their unique blend of protection and growth potential—an appealing option for investors looking to chart a steadier course through today's choppy market waters, says Myles Lambert, Brighthouse Financial.