Mutual fund derivatives plays heighten risk

Apr 23, 2007 @ 8:14 am

By David Hoffman

PHILADELPHIA — Derivatives are popping up everywhere — even in plain-vanilla bond funds — and it is making financial advisers and regulators nervous. “I think most investors don’t have a clue about the risk,” said Lou Stanasolovich, president and chief executive of Legend Financial Advisors Inc. in Pittsburgh. “A lot of mutual fund managers that use these things don’t even understand what they’re doing.” Despite such concerns, however, the use of derivatives in mutual funds, exchange traded funds, closed-end funds and other investments is expected to increase, according to industry experts. The reason is that asset managers can use derivatives to increase yield, and that is particularly attractive to baby boomers looking for income in retirement. This year alone already has seen the creation of products that use derivatives to achieve a higher yield, and they have been popular, industry observers say. One of the most popular was the Eaton Vance Tax-Managed Global Diversified Equity Income Fund, a closed-end fund from Eaton Vance Corp. of Boston. Its initial public offering in February raised $5.5 billion, making it the largest closed-end-fund IPO ever. Like its sister fund, the Eaton Vance Tax Managed Diversified Equity Income Fund, which raised $2.63 billion when it was launched in November, it uses covered-call options. Buyer beware The strategy can produce a greater yield, but that yield comes at a cost: It limits the upside potential of the fund if stocks for which the options are written go up. If that happens, the fund is at risk of losing the stock if it rises above the strike price of the call. As derivatives go, however, covered-call options are pretty straightforward, said Duncan Richardson, a portfolio manager and chief equity investment officer for Eaton Vance. “What you get is improved risk/reward of the stock itself,” he said. But some financial advisers said that derivatives of any kind make them nervous. It’s not that derivative strategies are bad, said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., a financial advisory firm in Amherst, N.Y., but derivatives are complicated, and it is up to the fund industry to explain the additional risks of such investments. He said he fears that it isn’t doing so. The same fears were expressed last month by Andrew J. “Buddy” Donohue, director of the Securities and Exchange Commission’s division of investment management. “It has been reported that many investors at the retirement stage of their lives are investing in funds based principally on the yield those funds may provide,” he said at a conference in Palm Desert, Calif., sponsored by the Investment Company Institute of Washington. “It is imperative that funds, and those who sell fund shares, are clear about how that yield is generated, whether that yield is from income, and the risks that may be associated with a fund and its yield generation techniques.” It’s a major concern, because investors may be taking on more risk than they realize, Mr. Donohue said.

At least one adviser said he recently took his clients out of a short-term-bond fund he once recommended, because it was investing in derivatives.

“I just started seeing in my imagination a lot of things that could go wrong,” said J. Michael Martin of Columbia, Md.-based Financial Advantage Inc.

But the mere presence of derivatives in a bond fund shouldn’t necessarily frighten investors, said Brendan Gau, a portfolio manager with the $556 million AIM Income Fund, an intermediate-term-bond fund offered by AIM Investments of Houston.

At the end of February, 70% of the fund’s assets were in derivatives, most of which, he said, were of a particularly tame variety — U.S. Treasury futures.

A very small percentage — 2% of its derivative exposure — was credit default swaps.

Protecting against defaults

Such derivatives are a form of insurance the fund uses to protect against defaults, not juice yield, Mr. Gau said. That can limit the upside potential of the fund. However, he argued, at a time when spreads to Treasuries are extremely narrow — which means that bond buyers are being asked to take more risk — such insurance makes sense.

That may be true, but using credit default swaps, futures or any derivatives makes it more difficult for investors to understand a fund, financial advisers said.

“Adding other factors, like derivative products, makes things very complicated to analyze,” said Patrick Hanratty, a managing director with Capital Advisors Ltd. in Cleveland.

And matters won’t be complicated merely for the investor, Mr. Donohue said last month at the ICI conference.

Call for due diligence

“Many fund firms’ systems, particularly compliance systems, may not be sophisticated enough to effectively handle synthetic instruments,” he said. “I am not trying to say that funds should not invest in these instruments, but I am saying that you should do a lot of work upfront before you wade into uncharted territory.”

For the most part, that’s exactly what the mutual fund industry — and the asset management industry as a whole — is doing, said Russel Kinnel, director of mutual fund research for Morningstar Inc. of Chicago.

But in a bond market such as the one we are in now, where yields are expected to remain low, and at a time when retiring baby boomers are going to be on the lookout for yield, Mr. Donohue is right to raise the issue, he said.

“As long as there [are] people who look at yield like they are choosing a money market fund or [certificate of deposit], there’s going to be someone out there willing to give them a dangerous product,” Mr. Kinnel said.

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