Orange County Voices : COMMENTARY ON COUNTY FINANCES : Don’t Blame Derivatives-- It’s Fund Managers’ Fault : All investments are risky, but proper guidelines and simple professional competence could have avoided this debacle.

The recent announcement of a $1.5-billion loss on Orange County’s investment fund has sent shock waves throughout the financial industry and may lead to renewed calls for regulations to control derivative products. This is misguided. At fault are the risk management guidelines (or lack thereof) and professional incompetence, not derivatives.

First, it is important to note that all financial investments are risky, for there would be no reward without risk. The issue is the amount of risk that investors are willing to stomach.

The $1.5-billion loss represents a fall of 20% in the $7.8-billion investment pool. To put things in perspective, a passive investment in the bond market would have lost only about 4% of its value since the beginning of the year. The abnormally large loss reflects the fact that the county’s portfolio was leveraged from two to three times its value. (“Leverage” involves borrowing funds to invest in additional risky assets.) The fund also used “structured notes,” which are complicated financial instruments involving the sale of “options.” But the main factor in the losses was leverage, not derivatives.

The first problem is that the fund managers implemented speculative positions with substantial downside risk, which were inconsistent with the responsibilities of running a public fund. Also, leverage may have been increased as an attempt to make up for losses incurred at the beginning of the year. Essentially, the pool operated as a “hedge” fund. Investing in private hedge funds should be allowed as long as investors realize that their capital is at substantial risk. The resulting exposure, however, was highly unusual for a public fund and was clearly unexpected.

The second problem is that investors who have benefited from the superior performance of the fund over the previous years should have suspected the strategy was risky. How else would the fund have been able to perform much better than the industry average?

Investors share part of the blame because they benefited from the superior performance and turned a blind eye to risks. In particular, the Board of Supervisors unabashedly supported the strategy, and failed to understand the magnitude of potential losses.

For a private corporation, such as Procter & Gamble, such speculative activity may be condoned by shareholders, who ultimately risk their own capital. In the case of public funds, it is not clear who bears the residual risk of such losses.

To address this control failure, I would suggest establishing a risk management system setting limits on leverage and on positions in derivatives.

Once in place, these guidelines should be monitored by an independent party, and portfolios should be valued at regular intervals using prevailing market prices. Instruments that cannot be priced or fully understood should be avoided.

Provided they are used prudently, derivatives are useful instruments.

In particular, derivatives traded on organized exchanges in Chicago are simple to understand, fairly priced and easy to value.

Derivatives are now actively used for the management of pension funds, which are subject to the strict fiduciary guidelines, established by the Employee Retirement Security Act, and have proved to be effective risk-management tools.

Overall, this loss can be squarely blamed on inadequate controls and professional incompetence. In any business, this combination would be deadly. Don’t blame derivatives again.