What are Derivatives? And How Do Funds Use Them?

Derivatives can be a valuable tool in a fund manager's armoury to reduce risk and hedge against stock market crashes

David Brenchley 22 January, 2019 | 8:37AM
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Derivatives, Futures, Options, Call options, funds, risk management, hedging

In 2003, famed investor Warren Buffett described derivatives as “financial weapons of mass destruction that, while now latent, are potentially lethal”.

And lethal they proved. In the run up to the 2008 financial crisis, major US banks and hedge funds repackaged sub-prime mortgages into investment products called mortgage-backed securities. But once interest rates had risen sharply and house prices tanked, many of these securities were worthless.

They eventually defaulted, with some going bankrupt and almost bringing down the entire global financial system. Other derivatives contributed to the financial problems at that time, including some credit-based products, including collateralised debt obligations.

Graham Neilson, investment director at Fulcrum Asset Management, managed credit derivative strategies that ended up performing “incredibly well” despite the global financial crisis.

The reason his did and others didn’t was because, he says, his team understood how they worked, realised the mistakes others were making, and knew that if their views were wrong, “the downside was absolutely massive”.

“Banks are supposed to be sophisticated users of derivatives, but that really was not the case in 2008 at all,” he says.

That episode has fostered a mis-trust in both banks and derivatives ever since, confirmed by headlines that have failed to show them in a positive light.

But asset management companies still use derivatives in their funds, largely for risk management purposes, says Emma Saunders, senior research analyst at Rathbones. They can be used to reduce risk, provide downside protection and enhance efficient portfolio management.

They can also help to dampen a fund’s volatility, as well as to take directional views – for example to allow managers to short an asset – adds Neilson.

On the fixed income side, they can also be used to adjust interest rate sensitivity, or duration, or to provide liquid access to parts of the bond market, adds Jonathan Miller, director of manager research ratings at Morningstar.

What Are Derivatives?

While most ordinary, retail investors will likely not use derivatives themselves, they should know what the funds they invest in do. Therefore, understanding how derivatives work and how they are utilised by asset managers is important.

“It is paramount to understand the use, type and purpose of derivatives in a portfolio in order to avoid unintended risks and consequences,” says Saunders.

Derivatives are products “whose value derives from, and is dependent on, the value of an underlying asset”. They are a way of gaining exposure to an asset – typically commodities, currencies or indices, stocks or bonds – without having to buy it outright.

They’ve been around for centuries, with the ancient Greeks and Romans making extensive use of contracts for the future delivery of goods. In 1688, Joseph de la Vega wrote a book on trading in Amsterdam in which he referenced put and call options.

Futures and Options

There are two types of derivatives commonly used in funds. Futures give the investor an obligation to buy or sell a particular asset at an agreed future date. Options are similar, but give the investor the right, not an obligation, to buy or sell an asset at a specific price at or before a given date.

These can be used to either speculate – betting that an asset will rise, or fall, in value in order to profit – or hedge an existing position – for example, buying an index future to offset a fall in a fund’s long-only portfolio.

While a futures contract can expose an investor to a large gain or a large loss, options generally allow for unlimited upside with a pre-defined maximum loss, which is set at the level of the premium paid.

For Fulcrum, its hedges were “valuable” in the fourth quarter of 2018. “In one strategy, we always have some sort of hedge in place in order to reduce the probability of an outsized loss,” explains Neilson.

That generally takes the form of a put option strategy on equities, which worked particularly well last year.

“In fact, if you put together October, November, December and January we are flat to slightly up across one of our main funds and that is broadly replicated across other funds, compared to equities that are down about 10% still," says Neilson.

“We expect to spend about 50 basis points per annum on hedging the portfolio. We think, as was proven last year, it’s a very worthwhile exercise.”

Covered Calls

While some funds use derivatives sparingly as a way to manage risk, others utilise them more prominently. Schroders, Premier, Fidelity and RWC run so-called ‘enhanced, ‘optimal’, or ‘optimum’ income funds.

These combine a vanilla, long-only portfolio with covered calls. The object of covered calls in these strategies is to increase the level of income produced and most yield anywhere between 5% and 9%.

Covered calls are where an investor will write a call option over a stock he or she already owns to the same value. This serves to set a cap on the upside an equity fund can achieve on its holdings in return for receiving a premium from writing the call that can then be paid out to fund holders as income.

This strategy is known as ‘covered’ because the downside from the call option, which would otherwise be unlimited, will be offset, or negated, by gains received via the fund’s long position.

“This strategy is likely to underperform the equivalent equity only portfolio when the prices of the shares held are rising strongly,” explains Geoff Kirk, co-fund manager of Premier’s Optimum Income and Global Optimum Income funds.

On the flip side, it has the potential to outperform when share prices are rising gently and is likely to outperform when prices are falling, he continues. “Therefore, the strategy is conservative, as it can mitigate losses to the downside and deliver less volatile fund returns.”

No extra risk is added onto the fund, as no leverage is introduced thanks to the ownership of the underlying stock. Further, he adds: “It is not necessary to take on any counterparty credit risk, as the fund has sold the options so the counterparty is exposed to the fund rather than the other way around.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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