Deriving a Knowledge of How Derivatives Can Work

RUSS WILES, a financial writer for the Arizona Republic, specializes in mutual funds

Mutual fund investment results are in for the first half of 1994, and they look pretty crummy.

Yet trying to figure out how much of the drab performance was attributable to the Big D--derivatives--isn't easy.

Derivatives have taken their share of criticism lately, for good reason. Although certain derivatives lower risk, others are speculative, and their use by some mutual funds has made those portfolios more volatile.

The reason it's hard to measure the impact of derivatives--a term that describes various types of financial instruments that one way or another are pegged to more traditional investments--is that fund companies generally don't disclose this information.

You probably won't read that a fund fell 5% during a quarter, 3.5 points of which were attributable to its derivative holdings.

A fund's prospectus might mention that the portfolio manager has the right to make use of certain derivatives, but even these explanations generally don't provide much insight.

Presumably, though, derivatives haven't exerted a significantly negative effect on most mutual funds.

"What it means to the retail fund investor so far is not much," says Roy W. Adams Jr. of Solon Asset Management, a bond investment advisory firm based in Walnut Creek, Calif. "That's because the vast majority of funds don't use derivatives, and most of those that do use them know what they're doing."

A survey released this spring by the Washington-based Investment Company Institute, the fund industry's trade organization, supports the notion of limited use of derivatives.

Some 1,728 funds, representing three-fourths of the industry's stock and bond assets, responded to the survey. Among them, the combined market value of all derivatives held as of late 1993 accounted for just 0.8% of total assets.

But not all funds reported using derivatives; in fact, nearly three out of four said they didn't. Among those that did, derivatives carried slightly greater weight--2.1% of their combined assets. Bond funds were heavier users of derivatives than were stock portfolios.

Significantly, funds tend to use derivatives mostly for hedging or reducing risk rather than for speculating, according to the institute's survey. In particular, funds often use derivatives to hedge against higher interest rates or foreign currency fluctuations.

Derivatives can also be used as an alternative to buying stocks or bonds directly, especially when it's cheaper and easier to make use of a substitute.

Suppose a stock fund gets a sudden influx of cash from investors. "The manager could buy a futures contract (to put the cash to work immediately), then take time buying stocks he likes," says Jim McCall, president and chief investment officer of Keystone Custodian Funds in Boston.

Similarly, the manager could sell a futures contract to reduce his market exposure quickly, then gradually unload the fund's actual stock positions.

As these examples show, derivatives aren't necessarily good or bad. Their effect depends on how they're used and how they complement a portfolio. What they all have in common is that their values somehow derive from or are pegged to prices of stocks, bonds and other traditional investments.

"Derivatives tend to get lumped together as a single class, but the intriguing thing is that they can operate in a number of ways," says A. Michael Lipper of Lipper Analytical Services, the fund-monitoring firm in Summit, N.J. "Most of the problems associated with derivatives involve leverage," he says, adding that mutual funds generally haven't used them in this manner.

Leverage magnifies market fluctuations, for better or worse. Only a small number of mutual funds appear to have stumbled recently from derivative usage, including government bond portfolios from PaineWebber, Piper Jaffray and Value Line.

More worrisome is that several companies that run money market funds have had to add cash to those portfolios to offset derivative-related losses. Fund managers have no legal obligation to subsidize setbacks on money funds, which aren't insured, but failure to do so could give rise to a greater problem: a wave of selling by shareholders.

For mutual fund investors, these tips regarding derivatives might prove helpful:

* Read the prospectus for signs that derivatives can be used by the portfolio manager. Possible red flags include references to "yield-enhancing" or "return-enhancing" strategies, as they could involve leverage, Adams says.

* Call the fund company or ask your broker to explain any legalistic discussion of derivatives in the prospectus. Again, be wary of references to leverage. "You'll be seeing a lot more in fund prospectuses on derivatives," Adams predicts.

* Monitor your fund's investment returns and yields in relation to group averages. "Look for a fund that's acting differently," Lipper suggests. For example, a short-term bond fund that returns 8% while its rivals advance 5% could be suspect.


Individual retirement accounts, long associated with tax-sheltered investing, might soon be thought of in another light: as an example of sex discrimination. That's because spouses who do not work for wages can sock away only $250 a year in an IRA, compared to $2,000 for wage earners.

A bill introduced in the House and Senate this year, the so-called IRA equity act, would address this disparity by allowing non-wage-earning spouses to contribute up to $2,000 a year. Mutual fund giant Fidelity Investments of Boston has joined various women's groups in supporting the legislation.

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