Why fund managers use derivatives

September 18, 2015 | Last updated on September 18, 2015
7 min read

Many retail mutual funds and ETFs use derivatives. For insights into the roles played by these instruments, we talked with Steve Hawkins, CIO and co-CEO of Horizons ETFs Management,and Alain Bergeron, senior vice-president of Investment Management at Mackenzie Investments. They shared thoughts about how derivatives help them manage market exposure efficiently.

Q: Why do fund managers use derivatives?

SH: Hedging is traditionally the largest use of derivatives in the mutual fund space, and there are more mutual funds coming out that integrate derivatives into their mandates. There are more covered call products, for example,which involve the active use of derivatives. But that activity is still within NI 81-102 restrictions (see “Derivatives regulations,” below).

One additional use of derivatives is to gain access to an asset class as a substitute to direct in-vestment. Let’s say you have a $100-million equity fund, and one day somebody puts $50 million into that fund. You may have the ability to invest that $50 million without significantly moving the market. But you can get $50 million in exposure through buying a call option, or by going long on a future.

Or, when it comes to commodities such as oil and natural gas, there’s a huge cost to invest in and store something like that physically. The spot market is very liquid on some commodities such as gold, but it’s just more efficient to trade some of them in the futures market.

AB: One main advantage of derivatives is you can change the exposures of a portfolio without disturbing the underlying investments in the portfolio, and the transaction costs are typically lower for the end investor.

We invest with a variety of portfolio managers. For example, if I want to reduce my beta exposure to U.S equities, I can choose to sell a portion of an investment in a U.S. equity manager. And, while selling will solve the beta problem, it could cause other issues.

Instead, if I sell or buy S&P 500 futures, I can reduce or increase my beta without moving anything else. Say we come up with a portfolio and we want it to have a beta of 0.7. Then, we see we have a current level of 0.75. We’ll sell a future against our holdings: selling an S&P 500 future is equivalent to selling the S&P 500 and, thus, to reducing exposure. To do this, we could initiate a new contract or add to an existing contract. This minimizes cost.

However, to reduce or increase beta, I wouldn’t use a forward. The main reason is that it’s standard practice to trade futures for equity indices and forwards for FX, or for currency hedging. Following standard practices leads to more liquidity and more efficient processes.

Let’s take another example. If we buy more of an international manager to diversify, we then get exposure to her beta, equity and sector or country exposure. That, too, shifts the allocation and weighting of portfolios. By changing or adding even one manager, you create a ripple effect. One way to mitigate that is to use futures to bring the country exposures back to an optimal allocation at the total portfolio level.

Q: How do managers hedge duration risk using derivatives?

SH: To hedge the duration of an interest rate-sensitive portfolio of bonds, we can do two common things aside from buying inverse bond ETFs: we can sell short futures or use swaps.

  • We can sell short the duration of the portfolio by selling something like a 30-year U.S. Treasury bond futures contract; these contracts are very liquid. We’d have a fixed interest rate on that 30-year bond. We’ll then be short a long-duration bond to reduce the term-to-maturity and the duration of the portfolio. The impact is you’re significantly reducing the portfolio’s sensitivity to a move in interest rates. If there were a 1% rise in interest rates, for instance, 30-year U.S. Treasury bonds could lose upward of roughly 18% (after shorting the duration of the portfolio). In Canada, there aren’t many fixed-income futures contracts that are liquid and traded on an exchange. There’s no Canadian 30-year, fixed-income futures contract, so people tend to use U.S. futures to hedge, even when they have Canadian exposure.
  • We can also use swaps actively to reduce duration. For instance, we can hedge the duration of a portfolio from five years to one year by putting a swap overlay on it. This helps because, if you have a portfolio with a duration of five years and interest rates move up by 1%, the prices in the portfolio, all else being equal, would drop by 5% (i.e., 1%) per year.

To keep the portfolio’s bond prices relatively flat, we want to have lower duration.

We do that by selling short a fixed rate of interest for a floating rate of interest through selling short a fixed-floating rate swap. By short selling a longer-term swap rate of interest, we’re reducing the duration more than if we sold short a short-term interest rate. The result is quite similar to shorting a 30-year U.S. Treasury bond.

Q: How do managers take advantage of market tilts?

AB: We analyze three main things: the current valuation of assets, the macroeconomic environment and how it may affect assets, and whether markets and investors are supportive of assets. We also look at historical data.

Let’s look at the Canadian dollar. We looked at several purchasing power parity valuation models, the macro environment and the market sentiment, and we believed over a year ago that the loonie would depreciate relative to the U.S. dollar. We dealt with this by reducing the amount of U.S. dollar currency hedging. First, we already had forwards to hedge a portion of our U.S. dollar exposure and, based on our view, we then changed the hedging of that forward so our portfolio was slightly more exposed to the U.S. dollar.

Essentially, we either add to, or reduce our existing contracts when hedging currency. If the team wants to increase a hedge, they buy another forward contract. If they want to reduce a hedge, they generally try to close out an existing contract. The vast majority of our futures contracts have short-term maturity; so, be-tween a month and a year.

If you don’t use derivatives, you could invest in an ETF that’s short the Canadian dollar against the U.S. dollar, but then you have to actually take cash away from investing in the market and put it into a currency hedge. And that ETF is also going to be using derivatives.

Q: How do options help reduce portfolio risk?

AB: Let’s say we buy $100 of equities and then there’s a big correction of 30%. Roughly speaking, an unhedged portfolio would also be down 30%. One way to reduce that risk is to buy put options, which give buyers the right to sell assets at a specified price in the future, for a premium. That reduces downside risk. But if you stop there, you’ll constantly be paying an unhedged insurance premium. In the long run, that will eat part of your return. You’ll have a smoother ride, but you’ll have surrendered some of the upside.

To reduce that constant drag, you can sell call options, which give purchasers the right to buy specified assets in the future at a specified price. By selling out-of-the-money call options, you actually get paid a premium that helps offset the insurance premium you’re buying with the put option.

Now, if stocks go up very fast, you still don’t capture all the upside since you’ve sold that call option. But, your fund should go down as much as its peers while also not giving up all the upside.

When we buy puts on equities, we like to buy nine- to 12-month puts, and we like to sell shorter-term (three- to six-month) options, and we let them mature and sell them again. We have similar amounts of calls and puts, but they have different maturities.

When it comes to bonds, one way to get more yield is to take on more credit risk. And, some people buy more credit risk than they realize when they pursue higher yield.

In our two monthly income portfolios, we’ve added less downside risk through the use of puts. If we buy high-yield without protection and they go down 20%, we’ll also go down. But if we buy puts, that means the more we go down, the more the insurance kicks in. We don’t sell calls, however, since high-yield has less upside than equity and, as such, the benefit of selling calls is less pronounced.

Derivatives regulations for mutual funds

Using derivatives to attempt to gain leverage in a mutual fund is restricted due to NI 81-102, explains Horizons CIO and co-CEO Steve Hawkins.

So, “when [mutual funds] use futures, they [must] have 100% of the notional value of that future covered [in] cash—[futures] are levered because you don’t have to buy them, and you just have to put up an initial margin of approximately 10% of market value. If you have a $100-million mutual fund and want $10 million of exposure to the index, you [must] have $10 million cash in your fund.”

Hawkins adds that typically, only active mutual funds use derivatives, primarily to manage portfolio risks. That includes hedging risk tied to:

  • currency,
  • exchange rates,
  • interest rates,
  • duration on a bond portfolio, and
  • general stock market volatility.