Question: The Analyst Report for one of my funds mentions that it uses derivatives. What exactly are derivatives, and how would a fund use them?
Answer: For some investors, the term "derivatives" may have a negative connotation because of the role these complex instruments played in recent financial disasters, including the global financial crisis that followed the bursting of the housing bubble and, more recently, J.P. Morgan Chase's (JPM) $6 billion loss last year as a result of risky trades made by the so-called London Whale. But even though these examples--both of which involve a type of derivative known as credit default swaps--highlight the potential dangers of derivative use (or misuse), many institutional investors, banks, governments, hedge funds, and corporations rely on them as a way to manage risk, pursue hedging strategies, and achieve other financial objectives. Likewise, mutual funds and exchange-traded funds are increasingly using derivatives as part of their investment strategies. More than one fourth of all U.S. mutual funds already use derivatives, according to Morningstar research.
A full discussion of how derivatives work could fill a book, but for investors curious to learn more about what they are and how some funds use them, here's a primer.
The term "derivatives" refers to financial instruments that derive their value from an underlying asset, such as equities, bonds, commodities, or real estate. Some types of derivatives, such as options and futures, might already be familiar to you. These, along with swaps, are among the most commonly used types of derivatives in the financial world. Here are some basic definitions and examples of these three commonly used derivative types.
Futures: Agreement between two parties to buy/sell an asset at some point in the future at a price that is determined today. Although originally developed for use in trading commodities, today commodity futures make up less than one third of futures traded. Other types include equity index (such as the S&P 500) and even interest-rate futures.
Sample uses: A farmer locks in a high price today for crops he will sell at a later date; an airline locks in future jet fuel prices today to guard against potential price increases at a later time.
Options: Gives its owner the right to buy or sell an asset at a given price for a set time period. Because the option represents the right to purchase the asset and not ownership of the asset itself, it typically costs just a fraction of the asset's price. These instruments may be used to gain exposure to equities, ETFs, equity indexes, and commodities. Options come in many varieties and can be used as part of many different trading strategies, such as betting that the price of an asset will go up or that it will go down.
Sample uses: An investor wants to hedge against price swings in a security he or she already owns (covered call); an investor wants to help protect his or her portfolio by buying some downside exposure in case of a market downturn (protective put).
Swaps: Agreement between two parties to trade different payment types over a given time period. These may be used to swap interest-rate or currency exposure, or credit protection (credit default swap).
Sample uses: A bank looking to reduce its exposure to floating interest rates paid on deposit accounts swaps that exposure with another party that can provide exposure to a fixed rate; companies operating in different countries swap currency exposures as a way to reduce currency risk.
Widely Used Among Funds
Mutual funds may use derivatives as a way to gain, hedge, or short exposure to a certain type of asset, often at a cost that is lower than it would take to own the position outright. Use of derivatives is prevalent across fund categories. A 2011 analysis by Morningstar found that funds in 83 categories held derivatives, including stock, bond, allocation, target-date, and alternative funds. Use of derivatives was heaviest in the intermediate-term bond category, with 128 funds owning 5,154 derivative positions in aggregate. Other fund categories with at least 1,000 derivative positions in aggregate included world bond, conservative allocation, nontraditional bond, foreign large-blend stock, and multisector bond.
Derivatives used by bond funds included bond index and currency futures and forwards, options on bond indexes and currencies, and interest-rate and credit default swaps. Stock funds, on the other hand, were more likely to use equity index and currency futures and forwards and options on indexes and individual equities. Alternative funds tend to be heavy users of derivatives--for example, trading futures and options as part of a long-short equity strategy.
As an example of how a fund might use derivatives, let's look at PIMCO StocksPLUS (PSPAX), a large-blend equity fund that aims to track the S&P 500, with a little bit of extra return thrown in. Rather than simply seeking to hold all the stocks in the index at the appropriate weightings, as a typical S&P 500 index fund would do, manager Bill Gross uses futures and swaps to gain exposure to the index and its price changes at a much lower cost. This allows him to invest the fund's large pile of unused cash in short-term bonds in an attempt to boost returns and beat the index. Another PIMCO fund, PIMCO Commodity Real Return Strategy (PCRAX), uses derivatives to track the Dow Jones UBS Commodity Index, providing diversified exposure to the commodities market while investing the fund's unused assets in a bond portfolio made up mostly of Treasury Inflation-Protected Securities.
Use of derivatives also is built into the DNA of so-called leveraged ETFs, which rely on them to execute some rather exotic trading strategies in some cases. Take for example ProShares UltraShort QQQ (QID), which is designed to deliver twice the inverse daily return of the tech-heavy Nasdaq 100 Index. On days when the Nasdaq 100 is down, the fund aims to deliver a positive return, times two. And on days when the index is up, the fund will have big losses. The ETF pursues its objectives exclusively through the use of derivatives such as futures and swaps, without holding any of the index's underlying securities. (An ETF like this also illustrates the potential risks of such a leveraged strategy in that a sizable gain in the index would result in a loss twice as large for investors. It should only be used by high-frequency traders and those hedging against or anticipating a near-term drop in the index.)
Transparency an Issue
By now you may be asking yourself, how can I tell if the funds I own use derivatives? It's a good question, as investors have the right to know how money they entrust to a fund company is being invested. However, disclosure of derivative use by funds unfortunately has been inconsistent. In a 2011 letter to the SEC Morningstar's John Rekenthaler, vice president of research, and Nadia Papagiannis, director of alternative fund research, summarized the problem this way: "The benefit of derivatives to investors is that they are primarily used to manage risk. The cost is that investors are frequently unable to discern the impact of derivatives in their funds. This is because fund companies are not reporting derivative holdings in a consistent manner and are not reporting derivative holdings in a manner that identifies the underlying risk exposure."
Further exacerbating the transparency problem is the fact that, while some derivatives, such as futures, are traded on regulated exchanges, others, including swaps, are traded privately in the over-the-counter market, potentially adding credit risk.
As for how Morningstar deals with derivatives in its fund asset-allocation data, it treats derivative positions based on the exposure they provide to the underlying asset. So stock futures would be counted in the percentage of assets held in stocks, bond options in the percentage held in bonds, and so on.(Long/short/net exposure to various asset classes is also provided; for further details on how Morningstar data handles derivatives, click here.)
The use of derivatives by some funds makes knowing how your fund works that much more important. Used properly, they can help manage risk and foster innovative investing strategies. But used irresponsibly, they can court disaster. As an investor, you owe it to yourself to understand how your fund works and whether derivatives are part of its approach. And if your fund company is less-than-forthcoming with this information, you have every right to demand it.
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I am a financial expert with extensive knowledge and experience in investment strategies, including the use of derivatives in funds. My expertise is grounded in a comprehensive understanding of financial instruments and their practical applications. Now, let's delve into the concepts mentioned in the article.
Derivatives: Derivatives are financial instruments whose value is derived from an underlying asset, such as equities, bonds, commodities, or real estate. Despite negative associations due to past financial crises, institutions like banks, hedge funds, and corporations, as well as mutual funds and ETFs, use derivatives to manage risk and pursue financial objectives.
Types of Derivatives:
- Definition: An agreement to buy/sell an asset in the future at a predetermined price.
- Example: A farmer locks in a current high price for future crop sales.
- Definition: Gives the owner the right to buy/sell an asset at a specified price within a set time.
- Example: Investors use options for hedging or protecting portfolios during market downturns.
- Definition: An agreement between two parties to exchange different payment types over a specified period.
- Example: Companies swap currency exposures to mitigate currency risk.
Use of Derivatives by Funds:
- Mutual funds increasingly use derivatives for gaining, hedging, or short exposure to assets at a lower cost.
- Different fund categories, including bond and stock funds, employ derivatives for various purposes.
- Leveraged ETFs, like ProShares UltraShort QQQ, utilize derivatives for exotic trading strategies.
Examples of Fund Usage:
PIMCO StocksPLUS (PSPAX):
- Uses futures and swaps to gain exposure to the S&P 500 at a lower cost.
- Allows the fund manager to invest unused cash in short-term bonds to boost returns.
PIMCO Commodity Real Return Strategy (PCRAX):
- Utilizes derivatives to track the Dow Jones UBS Commodity Index.
- Invests unused assets in a bond portfolio, primarily Treasury Inflation-Protected Securities.
- Disclosure of derivative use by funds is inconsistent.
- Morningstar highlights the challenge of discerning the impact of derivatives due to inconsistent reporting by fund companies.
- Transparency is a concern, especially when some derivatives are traded privately over-the-counter.
- Investors should understand how their funds work and whether derivatives are part of their approach.
- Properly used, derivatives can manage risk and foster innovative investing strategies, but irresponsible use can lead to disaster.
As an investor, it's crucial to be informed about the strategies employed by funds, including their use of derivatives, to make well-informed investment decisions.