The Companion Advisor: Techniques & Methods
Derivatives: Not so scary

A Companion Advisor Article

If you limited your reading to reports about boating and swimming accidents just before going to the cottage, your holiday would be ruined. Likewise, recent press attention has focussed on isolated cases of large investment losses through the mismanagement of leveraged derivatives. This has created a common perception of derivatives as scary and dangerous, a perception which contains more fancy than fact.

Derivatives are financial instruments that derive their value from stocks, bonds, currency, commodities, or a market index such as the TSE 300. The first kind of derivative is called a "forward" or "futures contract". It is an obligation to buy or sell a specific instrument at a specific price on a specific date. An example of a futures contract is your offer to buy a house at a specific price. If accepted, you make a downpayment today even though the closing may be months in the future.

The second kind of derivative is an "option", which gives you the right, but not the obligation, to buy or sell an instrument at a specific price before a specific date. A "call" option is the right to buy; a "put" option is the right to sell. The buyer of the option pays the seller a premium for the right to decide later. Let's say you closed the deal on that house and now you need renovations. You might pay a small amount to have a carpenter come over, take some measurements, draw up a rough plan, and give you a quote that is good for 90 days. You've just bought a call option on that carpentry job.

Mutual funds use derivatives in four basic ways:

1) To decrease risk. An international fund may use forward currency contracts to lock in an exchange rate and reduce the risk of currency fluctuations. This is called hedging, locking in a future buying or selling price in times of volatility, and is an important component of sound portfolio management.

2) As a substitute for direct investments. Stock index futures may be purchased instead of buying all the stocks the index represents. For the TSE 300, for example, it is more convenient to buy a future on the whole index than buying all 300 stocks. International RRSP funds buy index futures or futures on a selected basket of stocks in foreign countries while holding the equivalent amount in Canadian T-bills. Because the T-bills are in Canadian dollars, the investment is 100% RRSP-eligible while the fund gains international investment exposure.

3) To back up a belief in the direction of prices. A bond fund manager who believes interest rates are going to decline may buy an interest rate future or option directly, rather than bonds.

4) To provide liquidity and enhance returns. A futures contract requires a small down payment, freeing up cash for other uses. There may be lower custodial and transaction costs which enhance returns.

The use of derivatives by Canadian mutual funds is strictly regulated, both by type of derivative and by the manner in which derivatives are used. Mutual funds may use only certain derivatives with an approved credit rating that trade over-the-counter or on permitted exchanges, and no more than 10% of the net assets of a mutual fund may be invested in derivatives.

As well, mutual funds cannot use leverage or borrow money to buy derivatives. They can only use derivatives for hedging purposes or where sufficient cash or securities are set aside to meet the fund's obligations under the derivative security.

All investments carry risks. There are three risk factors when derivatives are used by mutual funds:

1) Liquidity risks. If a fund cannot "close out" or "sell out" its position, it may not be able to realize profits or limit losses. Or, if trading in the underlying security is halted, the prices of the derivatives may be distorted.

2) Credit risks. The fund's counterparties in the derivative, whether clearing corporations in the case of exchange-traded securities or other third parties in the case of over-the-counter obligations, may be unable to meet their obligations. This is minimized by dealing with only the most reputable firms and by increasing the frequency of payments.

3) Safekeeping risks. In certain circumstances, investment dealers and futures brokers will have possession of some assets belonging to the Fund in connection with the derivative positions.

You can learn if and how your mutual fund is using derivatives by reading the simplified prospectus and the footnote section of your mutual fund's financial statements or calling a Fiscal Agents - Investment Advisor.

Derivatives are very useful when used properly and, like insurance, can hedge against losses. Don't be misled by the horror stories produced when derivatives are misused, or you may end up sitting on the investment beach while everyone else is having fun in the water.

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