Mutual Funds in Derivatives: Risks Appear Minimal

The $2-trillion mutual fund industry has so far avoided the horrendous losses racked up by other players in the much maligned derivative-securities business. But are the funds next in line?

Probably not, for some simple reasons. Most funds appear to have dabbled in derivatives only minimally, usually risking less than 10% of their portfolios on these hybrid securities. And, because funds are required to reprice themselves “at the market� each day, any losses thus far should already be reflected in fund share values--that is, assuming the pricing of derivatives is accurate.

Therein lies the key danger in these instruments, though: Their complexity can make it difficult to properly value them day to day. Their complexity has also left many fund companies unable, or unwilling, to explain in quarterly reports to shareholders exactly how derivatives are being used. As with many other aspects of mutual fund ownership, the individual investor is asked to trust the fund manager to get it right.

Derivatives, as many investors know by now, are often-synthetic securities whose values are “derived from� underlying baskets of stocks, bonds or currencies, or from their relative movements. Futures and options contracts are derivatives; so are the much more complicated Wall Street creations such as collateralized mortgage obligations, derived from mortgage bonds.

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Most derivatives either give fund managers more bang for their buck (i.e., you can control a big chunk of securities for relatively little money down) or allow the manager to hedge in some way. In a typical hedge transaction, a bond fund manager fearful of rising market interest rates would buy derivatives designed to appreciate in value if rates rise--which thus would offset some of the expected depreciation of the conventional bonds in the portfolio.

The problem in recent months, particularly for bond funds (which tend to be bigger users of complex derivatives than stock funds), is that losses incurred by high-flying speculators in derivatives have roiled these markets, causing potential buyers and sellers to pull back. As liquidity has dried up, many derivatives that worked as advertised in 1993 have turned into unpredictable animals this year.

Benham Management’s $900-million Adjustable-Rate Government Securities fund, for example, owns some so-called IO bonds, or interest-only mortgage bond derivatives that usually jump in value if market interest rates rise. In theory, these bonds become more attractive as fewer mortgage holders prepay or refinance their loans in a rising rate environment.

We’ve certainly had rising rates this year. But Benham fund manager Randy Merk admits that the IOs “have not worked as well as expected. They’re not going up in value the way you’d expect, because there is so much (investor) reluctance to put bids out for these securities.�

Meanwhile, the Benham fund has suffered as another type of derivative--inverse floaters, a bet on falling interest rates--have tumbled in value while rates have surged.

Yet Merk says the fund’s investors have to put derivatives’ effect in perspective: All told, the IO and inverse-floater bonds account for 2.5% of the portfolio. The fund’s share price, now $9.68, has lost no more than 3 cents this year because of the fall in those derivatives’ values, Merk says. And even that is misleading, he says, because the fund’s yield would be lower without the derivatives.

Still, Merk admits he has pared back his derivative holdings over the past six months, as controversy over their use has ballooned. That retreat naturally makes derivative-free funds look smart in retrospect. Andrew Jennings Sr., head of muni bond trading at the giant Franklin Advisers fund group, says Franklin’s muni funds don’t buy derivatives, period. “We’re just very, very vanilla,� he says. “It makes our lives easier.�

Risk-averse investors may prefer that approach, but it’s also worth noting that many of the same funds that have suffered small losses because of derivatives this year also successfully used them to enhance performance last year. If you assume that derivatives aren’t going away, the best strategy for fund investors isn’t necessarily to run from funds that use them but to be willing to accept that these hybrids cut both ways. Your risk may be higher, but your return over time should be as well.

A Derivatives Lexicon

Some common derivatives used by bond mutual funds:

* CMO: Collateralized mortgage obligation. An umbrella term for securities derived from mortgage-backed bonds. Also known as remics (real estate mortgage investment conduits).

* IO: Interest-only bond. A mortgage derivative that pays interest only and does not receive principal payments on the bond. Thus, if paid off early, IO bonds become losers for their owners.

* PO: Principal-only bond. The flip side of the IO bond; owners get only principal payments. So they pay off quicker if interest rates fall and mortgage holders refinance.

* IF: Inverse floater bond. Common to both the mortgage and municipal bond markets, these derivatives are structured to pay more interest if market interest rates fall.

Source: Morningstar Inc.