Individual investors are not typically involved in the OTC derivatives market directly, but if you have invested in a mutual fund, unit investment trust, or other investment product, it is likely that some of your money is being used by your investment company in derivatives trading. That’s because, at a slowly increasing rate, many investment companies are beginning to include more strategies involving derivatives in their portfolio management techniques.

While this might initially seem like a dangerous strategy given today’s concerns about the risks associated with derivatives, investors do not necessarily need to be apprehensive. The fact is that, despite the potential for risk, there are several good reasons why investment managers choose to use derivatives.

To manage risk.

usa dollarDerivatives may come with risks of their own, but conversely, they can also be highly effective tools for risk management. One of the most common ways in which derivatives are used for the purpose of risk management is “hedging,” or the strategic use of market instruments to offset the risk of potential adverse price movements. In other words, investors or funds hedge, or protect, one investment by making another. For example, a US-based manager of a portfolio with a number of international investments might choose to use derivatives to offset the potential risk of an adverse currency movement that would affect the US dollar value of the fund.

In this context, it is important not to confuse “hedging” with “hedge funds,” which are not authorized investment funds and thus can make freer use of sophisticated financial instruments and may leverage, or invest borrowed money, in order to increase returns. Such practices are not permitted for registered investment companies; their use of derivatives is subject to strict regulation. In fact, the Securities and Exchange Commission recently proposed a new rule to place tighter restrictions on the use of derivatives by registered investment companies.

To reduce costs and allow greater flexibility.

One important advantage of derivatives is that they are often easier to buy and sell than the underlying holdings of an investment fund. Managers of funds that have large or illiquid share holdings, or tracker funds that must regularly change their portfolio mix in line with an index, usually find derivatives to be useful tools.

For example, if a manager plans to sell a share holding but is concerned that a lack of immediate buyers may result in a fall in the holding’s market price, a derivative (such as a put option) can be used to make the sale. This strategy allows the manager time to sell the shares gradually while still providing certainty about the ultimate sale price.

To generate investment returns.

stock climbingAlthough investment funds cannot use derivatives as freely as unregistered entities such as hedge funds, investment managers do use derivatives to a certain extent to help meet investment objectives. For example, rather than holding shares or bonds directly, a manager may hold a derivative of a stock market index in order to gain the same potential return. To use derivatives in this way, an advanced risk measurement system must be in place to ensure that daily regulatory limits are not exceeded.

Managers can also make use of derivatives to “short” markets, bonds, or shares, therefore potentially enhancing returns when prices are falling. However, regulations do not permit authorized funds to physically sell shares short; furthermore, collateral must be arranged to protect the fund against the risk of counterparty default, and the amount of exposure to a single counterparty is strictly limited.

What should investors do before investing in a fund?

Despite the many regulations in place, no investment strategy is completely risk-free, and individual investors should be aware that there is no guarantee that the derivatives strategy of a mutual fund or other investment product will succeed. It is therefore important for investors to carefully consider their own financial circumstances and risk tolerance before investing in a fund. Likewise, it is very helpful to conduct further research into how exactly a fund in question uses derivatives: do they form a core part of the investment strategy, or are they used only on a limited basis? Typically, fund documents like a prospectus or a statement of additional information will provide both a summary and a detailed description of the fund’s investment strategies. Investors may also find it useful to meet with an investment advisor to learn more about a fund’s strategies, and about the processes and risk controls that are in place.