Q & A : Derivatives and Money Funds: What Do They Mean to You?

Over the past few months, institutions and mutual fund managers have made one troubling announcement after another about losses on complicated financial products, generically known as derivatives. PaineWebber, BankAmerica and other fund managers have spent hundreds of millions of dollars to defray losses in pooled investments, including many that were considered low- or no-risk, such as money market mutual funds.

Thanks to the cash infusions, investors in publicly traded money funds have not lost principal. But that may change. Officials at the Investment Company Institute, a mutual fund trade group, revealed last week that at least one troubled money fund is searching for a buyer, presumably to cover derivative-related losses in the fund.

Are you at risk? Here’s the rundown on derivatives and how you can assess the likelihood of losses in your money fund.

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Q: What are derivatives?

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A: Derivative is a generic term for a wide array of complicated financial instruments that are derived from combining--or slicing apart--better-known products. Collateralized mortgage obligations, or CMOs, for example, are a derivative of mortgage-backed securities. To make CMOs, investment bankers slice up mortgage securities, giving one group of investors the interest-bearing portion and other investors the principal repayment portion.

Other derivatives combine products, such as interest-bearing securities and futures contracts, or futures contracts tied to varying market indexes. “Range notes” pay interest only when rates are within a certain range. Other common derivatives are “inverse floaters” and “capped floaters.”

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Q: Why were they created?

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A: Derivatives allow investors or institutions to limit or take a specific kind of risk. Traditional versions have allowed companies to nail down future costs, selling to others some of the risks of changes in the marketplace. Some have been around for decades, such as Treasury “strips,” which split bonds into interest and principal portions.

Others hedge or allow bets on oil prices or currency changes.

The ones that are currently causing problems were spurred by falling interest rates on bonds, certificates of deposit and Treasury bills. That caused suffering for individuals who live on the income and money managers who collect fees for managing assets and were nervous about losing investors.

A few savvy investment bankers created derivatives that theoretically would pay income regardless of declining market rates. Indeed, some of their new products would pay more income when interest rates fell--inverse floaters, for example.

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Q: Why are they wreaking such havoc now?

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A: Interest rates turned around, and many people who invested in these derivatives didn’t fully understand the risks. Yields on some of these products plunged far more steeply than anticipated as demand for them shrank.

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Q: Why would money funds invest in derivatives? I thought they were supposed to be invested only in short-term, risk-free government securities.

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A: Money funds do primarily invest in short-term Treasury bills and bank deposits. But the money fund business is competitive. And if a fund manager took just a small portion of the fund’s assets--maybe 5%--and popped it into derivatives, the fund might be able to boast returns fractionally higher than the competition during the days of declining rates.

Yield-hungry investors would then flock to the fund.

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Q: How do I know if my money fund invested in derivatives and is likely to take a hit?

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A: You have two options: Call and ask, or make assumptions based on funds returns.

If your fund was topping the performance charts while market rates were dropping--and if its prospectus says managers can invest in derivatives or “yield enhancing” securities--you have reason to worry.

If, on the other hand, the prospectus says all assets will be invested in cash or cash equivalents and your money fund returns are always run-of-the-mill, your risk is minimal.

Also, your risk is probably greater if you have invested with a small fund company rather than a large one, says Teresa Redinger, editor of IBC/Donoghue’s Money Fund Report, an Ashland, Mass.-based newsletter. That’s simply because small funds are rarely rich enough to pump cash into their funds to prevent investor losses.

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Q: Why have investment advisers been reimbursing their funds for derivative-related losses?

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A: Fear and competition, mainly. Some fear that if per-share values fall below $1--in other words, money fund investors lose principal--it could so spook investors that they would flee. They might flee all money funds, not just the bad ones.

Large family funds have an additional concern: If investors leave a money fund, they may leave the entire family.

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Q: What’s the worst-case scenario?

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A: That you could lose all of the interest earnings on your money fund investment and a portion of the principal. However, estimates of potential principal losses are modest--a few pennies on the dollar.

A money fund-like investment offered to Arco employees, for example, lost 5.3% of its principal last spring because of derivatives. In other words, your $1 share price would drop to 94.7 cents.