Who’s afraid of the big bad derivative?

12th August 2010

A lot of the newest and most innovative fund management strategies make use of derivatives. Yet they remain a source of bewilderment to many investors and a scourge to governments, who blame them for creating market volatility during the credit crunch. The discussion has been baldly split into those who believe derivatives are the devil's work and those who see them as a legitimate – and invaluable – portfolio management tool.

The first group may believe that fund managers shouldn't be dabbling in these ‘risky' instruments. Yet, in general, fund managers use derivatives for three purposes: to generate higher returns, to produce higher income and to protect their portfolio in times of volatility. In other words, far from using them for the wildly speculative purposes of popular myth, derivatives are most often used by fund managers for better management of risk.

For example, many of the absolute return funds will use Contracts for Differences (See: Elsewhere on MM) to profit from a falling market. This is equivalent to short-selling. In this way, they can deliver a positive return in all market conditions.

Short-selling has been widely covered in the media. This thread on the Motley Fool ostensibly discusses the German ban on naked short-selling, but brings in a lot of the prevailing views on the influence of the derivatives market.   BertEEE: "The CDS market is clearly being used for very speculative activity and some hedge funds are taking advantage of lack of liquidity in CDS IMO to create larger problems."

This thread on MoneyWeek also highlights some of strategies available through short-selling. As ever, the FT gives a measured view.

In all these discussions it is important to draw a distinction between short-selling and naked short-selling. Naked short-selling can be extremely risky, with potentially unlimited losses. Covered short-selling is a legitimate and valuable way of making money in falling markets.

Derivatives will also be used by fund managers to boost overall income. A number of income funds have started using this technique. Usually labelled ‘Maximiser' or ‘Enhanced Income', these funds sell covered options, meaning that they give up some of the potential upside of their holdings in return for an upfront payment.

Thomas See, head of structured product business development at Schroders says: "The real benefit of this approach is its flexibility. Active management of the option premium element allows us to make up for any shortfall in the underlying dividend yield. In other words, we do not have to sell out of low or non-dividend paying stocks at any price in order to maintain our yield. Equally, we can actively select non-dividend paying stocks that offer attractive total return without sacrificing our yield objective."

Again, this technique has a very different risk/reward profile from some other types of option trading.

But the most common use of derivatives by fund managers is for efficient portfolio management – hedging the portfolio against volatility and protecting returns against falls in the market. The risk for investors in most cases is simply that it adds trading costs to the fund.

Brian Mitchell, head of dealing at Gartmore, says: "Fund managers seek to hedge exposure from time to time in case changes in market conditions affecting particular industries or the wider economy cause sharp changes in the value of portfolio holdings.  Hedging would involve the establishment of positions which would generally – though not always – result in a profit to the fund when positions in the portfolio which are being hedged incur losses."

Some derivatives are undoubtedly dangerous and can cause instability in markets. But for the most part, they are firmly in the domain of the racy hedge fund manager rather than the conventional fund manager. For the most part, conventional fund managers use derivatives to iron out volatility and improve overall portfolio returns. They will not always be right, but the techniques they employ will not lose investors their shirts.

Leave a Reply

Your email address will not be published. Required fields are marked *