Are Derivatives For Risk Management or is Risk Management For Derivatives?

by: Richard Kang

Derivatives can be viewed quite simply. They are used by many as a hedging vehicle. A crop producer as well as the buyer on the other side. Bank and interest rates. Portfolio manager and a stock index. Gold miner. I can go on for a while. But of course, there’s always someone on the other side willing to take that bet.

My past articles have focused, in my opinion, too much on the ETF industry. The derivatives industry has a similar story of excess, abuse and a picture that is not all rosy despite many participants in the capital markets focusing solely on the positives and rightly so. Don’t get me wrong … I’m pro beta (my blog is called The Beta Brief, after all) and that means pro-ETFs and pro-derivatives. However, that’s not pro in the absolute. Because a very small number in this space manage to cause considerable confusion and/or distress, that’s the real shame.

This is an interesting posting on called Derivatives, Mutual Funds and Pensions. The author, Susan Mangiero, starts with this eye popping opening sentence:

Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That’s a lot of zeros - $400,000,000,000,000.

I’m not sure if that would be a value approximating the global total of all derivative contracts if we were to take a mark-to-market measure at some point (24 hour markets so there is no close), open interest or some other measure. But $400 trillion is pretty much the biggest number I think I’ve ever seen in this industry. The US public debt figure is the only number I can think of that gets into trillion dollar territory. If the derivative markets increase by another $100 trillion, we can say that it’s at roughly half a quadrillion. I kid you not.

Mangiero refers to a recent article by Eleanor Laise of the Wall Street Journal and here’s a short intro to the piece:

Funds’ use of derivatives — which Warren Buffett once called “financial weapons of mass destruction” — is growing as the instruments become easier to trade and as mutual funds aim to stand out in a crowded field. More automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds. And with more than 8,000 mutual funds on the market, many managers believe it’s not enough to match a market index. They want to beat the market — and derivatives often help.

So mutual funds use derivatives. Is that surprising? Mutual funds might be dinosaurs, especially compared to ETFs and hedge funds, but that shouldn’t stop mutual fund managers from doing their best to manage risks. For funds with significant international exposures, shouldn’t they use forward contracts to deal with foreign exchange risk? I would hope so. Again, I can think up many situations where derivative contracts would be applicable for fairly simple mutual fund mandates.

But according to Laise and highlighted by Mangiero is the fact that “automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds” and that “mutual funds aim to stand out in a crowded field.”

The list of questions Mangiero provides in her posting makes sense and I believe she has the good intention of having investors focus on risk management when determining if their mutual fund holdings are prudent for their situation considering the possible use (and potential abuse) of derivatives. However, I think that in general, mutual funds don’t get involved in derivative markets for anything other than the most basic of hedging strategies such as the FX hedge mentioned earlier. They just don’t have the incentive (compensation wise) to be opportunistic with derivatives in the same manner as hedge funds. This doesn’t mean that the type of investigative due diligence suggested by Mangiero is unnecessary … I think it is necessary, especially if there is evidence that the manager makes tactical/opportunistic decisions using derivatives or the wording on the offering documents is unclear (sometime purposefully to allow for maximum leeway). I just think that for most ordinary investors, this concern regarding the mutual funds they hold may not apply.

For pension funds, it’s a bit different because the external managers they use are expected to come with an added level of sophistication. It’s in the institutional realm that Mangiero makes this point clear with this lead up to the list of questions:

… a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager.

So derivatives can be used for hedging, defensive posturing and prudent risk management. Of course, because of the requirement for someone to be on the other end of the contract, there must be a speculator. It’s this end that I believe worries many including securities regulators and other capital market watchdogs. And this brings us back to hedge funds. LTCM, Barings/Leeson, Amaranth … they’re all about derivatives and a lack of risk management in their application. Issues of leverage and the bravado that led to such massive bets should be thrown in there as well as they are surely key. I know Barings wasn’t a hedge fund but so wasn’t Enron … or were they? I’ve mentioned in the past of the convergence between various alternative investment strategies and asset classes such as hedge funds, private equity, real estate, infrastructure and commodities. What also has to be considered are more traditional situations like a bank or energy company whose operations, if fully explored could resemble more of what a hedge fund looks like than what you may believe.

If true, then regulation/oversight on hedge funds (only) in regard to derivatives use would be unfair. The issue of risk management over the derivatives industry isn’t an easy one. It’s been discussed for so long and I’m wondering if “the powers that be” are waiting to see what happens during and after the next LTCM situation gone fully nuclear. A scary thought.

The first line of defense is always at home. Knowing the ingredients and recipe of what’s being cooked (or more importantly, what you’re eating) is in your best interest.