Last week, the U.S. Securities and Exchange Commission announced that it will begin evaluating the use of derivatives by mutual funds and exchange-traded funds. A derivative is essentially a security whose price is derived from one or more underlying assets, and the term is used to describe a range of activities including futures trading and default swaps. The SEC says that until the investigation has concluded, it will defer any new requests for ETFs that would make substantial investments in derivatives. The number of funds that engage in derivatives trading is growing, and the SEC wants to assess the risks associated with these funds.
For most investors, derivatives can be difficult to understand because of their complexity. “Derivatives are a sort of instrument that give market exposure without actually being a direct investment in that market,” says Eric Jacobson, Morningstar’s director of fixed-income research. “Whether it’s a bond, a stock, a currency, or an interest rate, a derivative generally gives you price exposure to something without you actually having to own that item.”
Jacobson says that there are a wide range of things that managers can do with derivatives, like shorting particular securities. At times, managers may use derivatives because they find them to be a good value. The problem is, says Jacobson, some managers have used them in a reckless fashion by taking on risks or leverage in the hopes of multiplying a fund’s returns. Some managers have failed and lost significant amounts of investors’ money.
The use of derivatives by managers is not necessarily a risky strategy. Some managers use derivatives to protect against volatility in their portfolios. “One of the things that the SEC is looking to figure out is if there are ways to categorize those usages, and perhaps even quantify them to some degree, so that the end user of a fund portfolio can better understand whether the derivatives are being using defensively, as an investment tool, or whether they’re being used especially aggressively,” Jacobson says.
The temporary halt in the approval of new ETFs that use derivatives extensively isn’t expected to impact the industry significantly. Tom Lydon, editor of ETFTrends.com, says ETFs that use derivatives only make up about 5 percent of the total ETF market. “The majority of ETFs are stock- or bond-based, but there are more on the inverse and leverage side, and commodities that use futures or swaps that the average investor may need a little bit of education as far as those underlying holdings,” he says. Lydon says most average investors shouldn’t use leveraged ETFs because of their complexity.