Does my Fund Invest in Derivatives?

VIDEO: New tools on Morningstar's fund view will allow investors to delve deeper into funds to work out exactly where their money is being invested

Holly Black 20 August, 2020 | 12:03PM
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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Kai Wu. He is an analyst with Morningstar. Hello.

Kai Wu: Hi. How is it going?

Black: So, Kai, Morningstar is introducing some new measures and ways that people can see whatever funds they are investing how it's using their money and part of that is going to be seeing if it's using derivatives. Now, that's quite a scary word. So, I'm going to start off by asking you what's a derivative.

Wu: That's a great question, Holly. So, derivatives are specialised instruments that help a fund manager manage control risk and return in their funds. And they are typically used because you can put down a small amount of money and manage a much larger chunk of risk within your portfolio. So, while most investors know of derivatives via things like CDOs and the 2008 financial crisis, the truth is that more often than not they are actually used to reduce risk. So, say, you're a U.S. equity fund that invests in stocks traded in euros, you tend to want to manage the exchange rate risk between these currencies. And for that you'd use a derivative. So, we're seeing more and more funds use these instruments and it's not necessarily a bad thing for investors. At the same time, we need to make sure that how a fund uses derivatives is transparent and it makes sense with their impact to the portfolio.

Black: So, when I look up a fund on Morningstar now, I'll be able to see this new measure economic exposure. So, how is that going to help investors?

Wu: So, for representing derivatives our focus started with our asset allocation view. So, for years, our asset allocation view has served as a catch all for representing sources of risk and return. And while our existing view is still correct from a financial theoretical perspective, it has certain limitations when translating the results to typical investors, particularly with funds that use derivatives. So, as a result of that, our economic exposure view updates our methodology to both minimize the impact of derivatives used for reducing risk and to highlight the impact of derivatives that are used for taking risks. We also created a new view called market value which represents where a fund invests their money. So, when you take these two together, these two views make it clear how derivatives in a fund impact its sources of risk and return.

Black: So, I guess, a lot of people think of derivatives as being quite opaque, maybe even secretive. So, where are you getting this data from?

Wu: So, to generate these views we actually collect specialized data points from funds that are tailored to derivatives. So, as such these new views are only available for funds that are providing us this information. Since we believe these new views are providing greater transparency, we've actually invested a lot of money and manpower in collecting this new data. And as the leader in collecting portfolio holdings we've had much success working with fund providers to get this data already. At the same time, we are seeing industry trends moving towards greater transparency as well. So, as such, we are looking forward to expand our coverage dramatically for this new view in the next few years.

Black: Okay. Well, that all sounds great in theory. But can you walk us through an example of how I can actually put these to use?

Wu: Sure. So, let's go through an actual example. So, this is a fund that uses derivatives to take equity risk in the market. And when you look at the classic view, you see large long and short allocations to fixed income, cash and other. These numbers make it really confusing as to what this fund is trying to do. Is it borrowing a lot of cash, is it shorting a lot of fixed income?

Now, let's a look at the economic exposure. By removing the impact of many derivatives, you see a clearer picture of what the fund is doing. Overall, it has an 87% allocation to equity, 71% allocation to bond and 39% allocation to cash. It's also leveraged to the market compared to its assets given that all these numbers add up to more than 100%. Finally, when you switch to the market view, you will see that most of the monetary value is invested in bonds. So, overall, this tells you that much of the cash and equity exposure are coming from derivatives. So, using the market value view with the economic exposure view you get a very clear picture of that this fund is leveraged and it's both a 100% invested in equity approximately and also roughly 100% allocation to bonds and cash.

Black: Kai, that's fantastic. Thank you so much for your time. For Morningstar, I'm Holly Black.

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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Holly Black  is Senior Editor,


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