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The Use of Derivatives in Mutual Funds

Mutual funds should be allowed to use derivatives.

Terry Tian, 04/18/2012

In a recent comment letter to the SEC, Michigan senator Carl Levin urged the regulators to consider how the use of derivatives in mutual funds is "diverting investment dollars away from stocks and bonds toward commodities, increasing speculation in the commodity markets, and contributing to greater commodity price volatility, price distortions, and a weaker economic recovery."

Levin's reasoning is problematic and flawed in logic.

The Misconception of Mutual Funds' Use of Derivatives
The U.S. mutual fund industry has been operating under the Investment Company Act of 1940, at which time there was no active derivatives markets. As a result, the regulation on mutual funds' use of derivatives was not designed to accommodate today's market conditions.

Derivatives, such as futures and forward contracts, options, and over-the-counter instruments, have often been seen by the public as speculative in nature--like Sen. Levin puts it in his letter--"derivatives investments frequently amount to little more than bets on the performance of referenced assets or issuers and do not contribute to capital formation."

Admittedly, derivative trading is "zero-sum" (one party's gain is the counterparty's loss) and "leveraged" (derivatives are typically traded on margin, in which a small upfront investment is linked to a much larger notional value). However, Levin's statement fails to recognize one of the most important reasons for derivatives to exist and also the primary purpose for mutual funds to use them--managing and sharing risks.

Derivatives facilitate the transfer of risks from one party to another based on their needs, so that the financial market as a whole would achieve an efficient allocation of risks. For example, if an international-equity fund manager does not want to take the exchange-rate risk of his foreign-stock holdings, he can use currency forwards to shift the risk to someone who would like to take it. A fixed-income fund manager can use Treasury futures to adjust duration risk to his desired level and use credit-default swaps to manage credit risk. Today's derivative markets offer the most cost-efficient way (sometimes the only feasible way) to gain, hedge, or short exposures in certain assets. As a result, derivatives are widely used by mutual funds. As of last November (when Morningstar submitted a comment letter to the SEC), about 27% of the 6,809 distinct U.S. mutual funds reported at least one derivative holding. The reason for the vast majority of these funds to engage in derivatives trading is to minimize (hedge) certain types of risks rather than to amplify them.

Commodity Price Volatility and Distortions
Levin attributes today's higher commodity prices and volatilities to the mutual funds' and exchange trade products' (ETPs’) use of commodity derivatives. He cites examples from crude oil, natural gas, and wheat markets, saying "speculators contribute to escalating and unpredictable energy, metal, and food prices to the detriment of American families and businesses." This is hardly the case.

Mutual funds that trade commodity derivatives are still niche investments and only represent a tiny portion of the total volume of global commodity trading. There are only 30 funds in the Morningstar commodities broad-basket category (which trades commodity futures), with total assets of $56 billion (as of Feb. 29). According to Reuters, global daily contract turnover in the oil markets alone is more than $200 billion. The assets coming from mutual funds, then, can hardly move the needle of any commodity prices. Other fundamental factors are more-plausible explanations for today's high commodity prices, such as the development of emerging economies (notably China) and their thirst for raw materials.

Terry Tian is an alternative investments analyst at Morningstar.
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