Use of some types of potentially explosive derivative securities in mutual funds is considerably more widespread than investors are aware, according to investment consultants and investment software developers.
But like some money market fund portfolio managers who recently fell into trouble using exotic derivatives, managers of other kinds of mutual fund portfolios probably aren't using software analytics and other tools to understand how the derivatives will react in various economic scenarios, they say.
Powerful derivatives used in mutual fund portfolios can result in losses that, by some estimates, already amount to several hundred million dollars this year.
In some cases, money managers claim they know or suspect they are taking risks by using exotic derivatives to enhance their portfolio performance. Some managers say they decided to take calculated chances anyway. However, Jim Kaplan, president of Capital Management Sciences, Los Angeles, provider of analytic software used by more than 1,000 investment professionals, believes money managers might not be running simulations on their portfolios often enough to know the risks as economic conditions change, or might not have a complete set of analytical software tools.
A manager's lack of understanding about how derivatives behave is precisely the financial danger to investors, including those in 401(k) plans that use mutual funds.
The use of derivatives in fixed-income funds in particular can change the general risk profiles of the funds, and the way investors should look at them.
Some mutual funds caught up in the uses of derivatives were PaineWebber Group and Piper Jaffray Cos. In July, PaineWebber officials said the firm would spend $180 million to bail out a mutual fund pounded by its holdings in derivatives. In late August, it was reported that Piper Jaffray could have lost several hundred million dollars through the use of derivative instruments. And the New York state attorney general's office is investigating whether some mutual funds misled investors about the safety of the funds.
Mr. Kaplan of Capital Management Sciences said he doubts the use of derivatives has been isolated to a few money market funds.
Use of the more exotic derivatives in some mutual funds "is a big deal and it is going to mean a lot of trouble. .*.*. Some of the surprises could be positive, but I think there is going to be a lot of negative surprises," he said.
Referring to the use of derivatives in mutual funds, John Rekenthaler, editor of Morningstar Mutual Funds, Chicago, said: "There are others using exotic derivatives. We have seen some problems, and no doubt we will see some going forward. (Derivatives) are here to stay."
Scott Lummer, a consultant and managing director at Ibbotson Associates, Chicago, said when used correctly, derivatives do "an awful lot of good" in mutual funds. But he said some derivatives haven't been used correctly and because of that, some mutual fund investors could face new dangers.
"I am aware that a lot of people are using derivatives to a certain extent and probably don't fully understand the impact of those derivatives on the risk profile of their portfolio," said Marco Vangelisti, manager of the client support division at BARRA Inc., Berkeley, Calif.
Derivatives are complex securities whose investment returns are derived from other investments, such as ordinary collateralized mortgage obligations.
Derivatives makes sense in mutual funds when they are used to quickly lengthen or shorten portfolio maturities. When used in such ways, portfolio managers would be wrong not to use derivatives, said Mr. Lummer.
Typically, investment managers are unaware of the dangers of some exotic derivatives because they buy them periodically over years when economic conditions are favorable for particular kinds of derivatives and the securities seem tame. However, derivative securities can blow up under economic conditions managers don't anticipate.
"For the first time in 12 years we saw a serious kick-up interest rates. ... It's the first time that the dangers (of using derivatives in mutual funds) have been unmasked," said Mr. Lummer.
Even though the dangers are unmasked, mutual fund money managers are expected to continue to use exotic derivatives, according to developers and consultants.
At the same time, some mutual fund managers, unaware of the dangers, won't use analytical tools to model how the securities will behave, or they won't have a complete set of analytical tools to do the job. Overconfidence also could cause some mutual fund managers to bypass outside consultants for help in understanding derivatives.
Capital Management Sciences' BondEdge software program displayed what would happen to the return of a collateralized mortgage obligation bond from the Federal Home Loan Mortgage Corp. (Freddie Mac). Using various interest rate scenarios, a BondEdge simulation showed the effect on the CMO derivative if interest rates fluctuate 200 basis points. Under a falling rate scenario, the return would be 3.4%, far lower than the typical investor would have expected.
Under a rising rate scenario, the return is -11.11%. For a security that is supposed to be protected (whose payments are dependent on a pre-defined schedule), the decline is far greater than one would expect from a cursory examination of the security.
One key reason managers will continue to use more exotic derivatives is competitive pressures.
Some of the stiffest competition is among the managers of government securities funds. Managers of government funds don't have the extensive choices available to investors in corporate securities.
Derivatives "are a natural selling point to government (securities) managers who are looking to add some value or looking to get a bonus or justify their salaries or overcome their expense ratios," said Morningstar's Mr. Rekenthaler.
But Mr. Kaplan questioned the use of derivatives in other mutual funds. Money market funds are meticulous in trying to preserve the unit price of $1 per share: "What about the mutual funds that don't have that restrictive limitation - the standard short-term bond funds, the corporate bond funds (as well as) government funds? It's a huge market."
Derivative securities can be put together in so many ways, some investors who might even be on guard about derivatives still could be hurt without the right analytic tools.
Mutual fund managers "are going to get bruised, but they don't know how yet. They are only going to defend themselves against those elements that have already affected them adversely. The mutual funds have little or no mechanics in place. I know that. They probably have accounting systems. They have no appropriate analytics," said Mr. Kaplan.
According to Mr. Rekenthaler, the use of derivatives in mutual funds has become more common in the past couple of years. "What you have are funds that two years ago didn't really invest in mortgage derivatives because there really wasn't much product out there and the fund industry really hadn't found those securities until the last couple of years."
In the past, bond funds particularly were viewed generally as a lower-risk investment than stocks. But looking at the history of a bond fund might not be as useful as it has been in the past.
"There are funds developing new characters because they are embracing these new and relatively untested securities. And it makes it more difficult to do research, and it is tougher to say with certainty how a fund positions itself. The field is changing and changing rapidly," said Mr. Rekenthaler.
"The behavior of these funds can be shifted radically now. That is the real issue. You can't really look at historical performance. I am not even going to talk about the stock funds, but it is also true there," said Mr. Kaplan.
Many mutual funds provide little information about how they use derivatives in mutual funds. The use of derivatives in shareholder reports "is not necessarily labeled or not enough detail is given in many cases so that even a trained professional can understand exactly what kind of derivatives are used or how they might behave," said Mr. Rekenthaler.
Reports that the Securities and Exchange Commission is studying the use of derivatives in mutual funds may be overstated. An SEC spokesman said, "I am not aware of any study ongoing other than surveillance."
Companies might have to examine the portfolios of some mutual fund themselves, but only if they have the tools and know what's in the portfolio. "Obviously if you don't want to take a lot of hard questions from (angry) employees, you want to give them products that behave something like what you tell them. It's my understanding that there are potential legal ramifications maybe down the line too," said Mr. Rekenthaler.