Investing in mutual funds with derivatives exposure requires a sober assessment of the risks
As retail investors are set to gain access to liquid alternative fund strategies, many advisors and their clients have reason to be wary of complex bets. But as a popular expression goes, the poison is in the dose. Put another way, the risk is in the exposure.
“[S]ome investors might be leery of alternatives funds that invest heavily in derivatives because a few of these funds have blown up in the past,” wrote Tayfun Icten, senior analyst for Morningstar, in a recent Forbes piece discussing a flavour of liquid alternative funds in the US. “[But] it’s probably a mistake to blanket rule out alternatives funds that rely on derivatives to invest.”
According to Icten, such funds must be considered based on two key dimensions. First is the degree to which a strategy uses derivatives. For example, credit long/short strategies that opportunistically bet on or against bonds might depend heavily on derivatives, while long/short equity strategies might have only trace exposures.
“[I]t doesn’t necessarily mean the former is a lot riskier than the latter,” he said. “Rather, what matters is the type and magnitude of exposures that those derivatives confer to the assets concerned.”
He compared a strategy that invests a large portion of its assets in derivatives as part of a hedging strategy with an 80% stocks strategy that puts the other 20% in a leveraged bet on the direction of the broader stock market. “In this example scenario, the derivatives-laden strategy presents less market risk than the derivatives-light strategy,” he noted.
The second factor to consider is how the strategy gets derivatives exposure and how much leverage that requires. A strategy might rely on credit from an outside source such as a prime broker, which could present a danger in case the lender calls in those borrowings. The degree of borrowing, whether the fund invests in the equity or mezzanine piece of a structured-credit product, and whether it margins — posts some portion, and not the full amount, of the dollar exposure delivered by a derivative — also matter.
“For mutual fund investors, it’s important to know how much margin a strategy uses to trade futures and options,” Icten said. “Margin—and risk—can be high for managed futures, options-based strategies and some alternative fixed income strategies like non-traditional bonds and long/short credit.”
To help investors and advisors assess the usage and risks of alternative strategies with derivatives, he shared the following suggestions:
- Check the holdings in disclosures filed with regulators.
- Size the exposure by deriving the total notional value from long positions and short positions. If the notional derivatives exposure is larger than the fund’s net assets, the fund “may be placing what amounts to a large directional bet financed with leverage.”
- Size up the collateral the fund’s holding in reserve, which could blunt the risks from its derivatives investments.
- Determine the reference assets tracked by the derivatives, as the volatility of those assets could impact the amount of leverage that’s advisable.
- If possible, stress-test the strategy in different market conditions.
- View derivatives in a broader portfolio context, particularly whether they serve a purpose in concert with a portfolio’s other holdings.
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