Cost & Efficiency
Derivatives can enhance liquidity and flexibility in fund management. From time to time, sectors may appear attractive due to sharp market moves, while bonds providing exposure to those sectors might be scarce. Instead of potentially overpaying, a manager might use a credit-default index to quickly adjust market exposure at a lower cost. This can be especially useful during periods of market volatility or when managing cash flows from investor redemptions. This is by no means free: Holding positions incurs costs through margin requirements and transaction fees, so fund managers must employ these contracts prudently. Nevertheless, by using derivatives strategically, especially during periods of market stress, funds can help maintain performance consistency and reduce transaction costs.
Regulation
The GFC shed light on derivatives and their misuse. Following that period of chaos, regulators implemented measures to address the risks posed by the overexposure and leverage these instruments can introduce. Reforms such as Dodd-Frank and Basel III created guardrails around which entities can trade certain instruments, how parties must collateralize, the use of margin positions, and more robust transparency around reporting requirements.
Moreover, mutual funds and ETFs are governed by strict regulatory frameworks. In October 2020, the SEC adopted Rule 18f-4 to further regulate the use of derivatives and other transactions involving leverage by registered open-end funds. Under this rule, funds must:
- Adopt a written program to manage derivatives risks;
- Designate a Derivatives Risk Manager approved by the board; and
- Include stress testing, back testing, and breach reporting.
Additionally, fund disclosures, including those found in prospectuses and fact sheets, must detail how derivatives are used, to help investors make informed decisions.
Strong Hands
Finally, much like a musical instrument that’s only as good as the person playing it, the investor using the derivatives, and their intent, matter much more than the derivative itself. The idea of “strong hands” refers to sophisticated investors or institutions that hold assets with conviction, maintain long-term investment horizons, and possess deep capital reserves. Mutual fund and ETF managers, in addition to being highly regulated, typically understand what an overleveraged or overexposed position can do to their reputation if they’re caught offside.
For example, a core bond manager could be subject to significant outflows if drawdowns vs. peers are more significant due to excessive derivative risk. Ironically, the lack of derivative usage for risk mitigation might make the manager appear unsophisticated if they could have protected capital better during a risk-off event.
Professional fund managers generally use sophisticated risk models and oversight to help ensure derivatives serve their intended purpose. They would be wise to keep the words of Warren Buffett top of mind: “It takes 20 years to build a reputation and five minutes to ruin it.”
Conclusion
When used appropriately, derivatives may not a source of undue risk—they can serve as tools for mitigating risk and enhancing portfolio efficiency, ultimately aiming to protect investor capital. In the aftermath of the GFC, heightened scrutiny reshaped the derivatives market, compelling end users to adopt stronger risk-measurement practices and greater transparency. Today, sophisticated investors—focused on long-term goals and mindful of their reputations—approach derivatives with discipline. They understand that excessive leverage can erode credibility as prudent stewards of capital. Thoughtfully applied, derivatives remain an essential component of the investing landscape, offering meaningful benefits to those who use them wisely.
