Widely Used Derivative Investments Focus of Wall Street Debate : Finance: High-tech, complicated and largely unregulated, they could be ‘too much of a good thing.’

NEW YORK —  When they evaluate the quality and safety of an income mutual fund these days, many people now make a point of asking where the fund stands on derivative investments.

These types of investments--high-tech, complicated and widely used--have become the center of a debate on Wall Street reminiscent of the debate over computer program trading in the 1980s.

When derivatives in their many guises are used prudently, their advocates say, they can serve to increase yields, reduce risk or limit the costs of investing for current return.

But numerous skeptics complain that they aren’t always put to prudent use, and that they could cause some big headaches before long.

“Derivatives are useful and innovative tools when used properly,” says Randy Merk, a senior vice president and fund manager at the Benham Group in Mountain View, Calif.

At the same time, Merk observes in the firm’s latest bulletin to investors in its mutual fund family, “derivatives prove that you can indeed get too much of a good thing.”

To some, that’s an understatement. “Critics of the derivatives market, including myself, have always feared that there could be some computer nerds out there using derivatives to build the financial equivalent of an atom bomb,” says Raymond F. DeVoe Jr., an analyst at the brokerage firm of Legg Mason Wood Walker Inc.

“Faulted strategies traditionally are discovered under stress,” DeVoe adds.

The term derivatives encompasses a wide variety of financial products with exotic names like interest-rate swaps, Treasury strips and collateralized mortgage obligations. They are, in effect, synthetic concoctions derived from more traditional securities such as stocks and bonds, or from naturally occurring economic phenomena such as currencies and loans.

Their main proponents are large money-center banks, who use them for themselves and provide them to a wide array of customers that includes many income mutual funds.

“The level of concern is ironic because derivatives are used primarily to reduce risk,” says James Benham, the Benham Group’s chairman, in a commentary accompanying Merk’s. “Some concern is indeed justified, however.

“The derivatives market is still largely unregulated. They are typically not traded on exchanges and are not subject to disclosure laws and government regulation, largely because lawmakers don’t understand them well enough to write laws to govern their use.”

In the case of interest-rate swaps, based on deals between banks, Benham says, “swaps increase the possibility of financial market gridlock in the event of a crisis such as a global market crash.

“Growing and pervasive derivative use complicates the identification of banks that are in danger of failing. This could cause the financial system to stall in a crisis situation until swaps and other interrelationships are sorted out.”

Derivatives are a challenge for mutual-fund investors to comprehend as well. While some funds are very helpful in trying to clarify the subject and making public how they use derivatives, others don’t do such a good job.

“It’s nearly impossible for the individual investor to know the risk characteristics of these,” observes Chip Norton, managing editor of the financial newsletters published by IBC-Donoghue Inc. in Ashland, Mass.

“You almost have to leave this up to the judgment of the portfolio manager.

“A lot of the managers we talk to are very cognizant of the risks,” Norton adds. “That’s not to say all of them.”

At the extreme, Norton suggests, fund investors who decide they absolutely don’t trust derivatives can seek out a fund that, in its prospectus or other explanatory literature, specifically rules them out.

“I wouldn’t go so far as to say it’s a ticking time bomb,” Norton says. “But it could be a small fire that no one’s looking at at the moment.”