Mutual Funds Don’t Need Risky Derivatives

Posted on December 2, 2011
Filed Under Mutual Funds, The Economic Scene

In this article in Financial Advisor, we learned that a few major mutual fund companies are asking the SEC to back off on its proposal to restrict the use of derivatives in traditional mutual funds.

“Any set of mechanical rules cannot take account of the diversity of derivatives and the multiplicity of ways they may be used by portfolio managers,” BlackRock managing directors Joanne Medero and Ira Shapiro said in a Nov. 4 letter to the SEC. “Used appropriately, derivatives can be effective tools in seeking to achieve returns and control risks in funds.”

Here’s a case where we back the SEC and think the industry leaders are wrong.

Mutual funds should be what they originally were – baskets of stocks or bonds watched over by professionals. Period. There is no clear need to muddy the waters with other instruments like derivatives.

Maybe I’m old fashioned. When I started delving deeply into the world of mutual funds in the 1970’s, mutual funds were uncomplicated affairs. Each fund had a clearly described mandate, and they ought to stay that way.

Derivatives have the potential to cause unexpected turbulence. As SEC Chairman Mary Schapiro says, “A relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss––or outsized exposure to an individual counterparty.”

The fund companies (and so far, it doesn’t appear that Fidelity mutual funds are part of this movement) say they need derivatives to help them control risk. To which I say, “No.”  If I want a fund that is fully invested in the stock market, don’t play games. And if I want to control risk for myself or my clients, I can easily do it by either investing in a bond fund or a money market fund. In other words, the funds should do what they are paid to do.

The same concepts, of course, would apply to funds whose objective is lower risk – they can “control risks” without resorting to derivatives. Let’s never forget that the financial crisis of 2008 clearly taught us all that derivatives are not nearly as simple as their inventors wanted us to believe.

And finally, I couldn’t believe it when I read this…

“Provided ETFs offer sufficient transparency, their investment in derivatives should not raise any additional concerns,” said Phillip S. Gillespie, executive vice president and general counsel of Boston-based State Street’s investment-management arm.

Derivatives “should not raise any additional concerns”?! Haven’t we heard that line before? Amazingly to me, they still want us to believe it.

So when it comes to traditional no-load mutual funds “needing” derivatives – I just don’t buy it.



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