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Bridge over ocean
1 November 1999 CFA Institute Journal Review

How Are Derivatives Used? Evidence from the Mutual Fund Industry (Digest Summary)

  1. William H. Sackley

The authors use a relatively large sample of mutual funds to determine the
characteristics that control derivative usage and its impact on fund risk and
return. The most significant results show that after controlling for a fund's
objective, the use of derivatives affects neither risk nor return. A negative
relationship is observed between performance in the past period and changes in
risk. The relationship weakens with derivative usage.

How Are Derivatives Used? Evidence from the Mutual Fund Industry (Digest Summary) View the full article (PDF)

The use of derivative securities in a portfolio context evokes various thoughts as to the
anticipated outcome. Will overall risk be reduced, consistent with hedging principles?
Will transaction costs be reduced, thus enhancing returns? Or as often illustrated by
the popular press, will derivatives be used to speculate with the expectation of
increasing both risk and return? The authors undertake an extensive study of derivative
usage within the mutual fund industry and attempt to identify the impact of usage on
portfolio returns.

Using a sample of 679 U.S. equity mutual funds, as classified by Morningstar Inc., the
authors gathered returns for the 1992–94 period. Derivative usage by a fund was
determined through telephone surveys and backed up by the fund prospectus. Approximately
21 percent of the sample of funds used derivatives. Levels of derivative usage were not
statistically different for the five categories of funds studied. Approximately 45
percent of the funds tied derivative usage to hedging, and only 9 percent admitted to
using derivatives for speculative purposes. Less-exotic derivatives, specifically
options and futures contracts, represented the contracts most commonly used by the
funds.

The authors find that certain fund characteristics predicted derivative usage.
Specifically, a fund's being in a large family of funds as well as having high asset
turnover suggest greater derivative usage. Being part of a large family of funds may
indicate that a fund has greater access to resources with which to monitor derivative
usage than other funds have. The authors also find that within a family of funds, having
high asset turnover and low load fees and being categorized as a growth and income fund
increase the likelihood of derivative usage.

When comparing the risks of funds that use derivatives with the risks of funds that do
not use derivatives, the authors find, surprisingly, no systematic differences after
controlling for the funds' objectives. Aggressive growth funds display greater risk than
equity income funds, but the use of derivatives does not make the funds either more or
less risky than their category counterparts.

If not affecting risk, perhaps derivative usage by funds permits trading at lower
transaction costs or allows the inflows and outflows of funds to be more efficiently
handled. If so, then funds using derivatives should have higher returns after adjusting
for trading costs than the returns of funds that do not use derivatives. The results are
similar to those concerning risk: No significant differences are found in performance
based on a fund's use of derivatives.

Finally, the authors test for the existence of a relationship that is based on previously
reported findings: Managers increase risk in periods after poor performance and decrease
risk in periods after good performance. If a relationship exists, the reason could be
because of either incentive gaming on the part of managers or the inability of managers
to respond promptly to changes in cash flows experienced by the funds. The results
indicate support for both hypotheses, but the negative relationship between previous
performance and changes in risk is weaker for those funds that use derivatives than for
funds that do not. The weaker results are primarily confined to the category of
systematic risk. This finding suggests that managers who use derivatives are able to
reduce the impact of performance on risk, possibly through the use of stock index
derivatives.

Legislation included in the Taxpayer Relief Act of 1997 facilitates mutual funds' use of
derivative securities without risking their pass-through tax status. As a result of this
legislation, usage patterns could change, but the impact on risk and return may not be
significant.