When Good Tools Are Used Inappropriately, Bad Things Happen

by and | Oct 7, 2020 | bytesize, Derivatives

No, all derivatives are NOT the same

Derivatives are a tool, nothing more, nothing less.  Just like any tool, if used inappropriately, they can cause more harm than good.  Derivatives, such as options on equity indices or futures on interest rates, properly used can be very useful tools for investors. They are used to manage risk and to provide greater certainty around the path of future investment returns. However, when they are used improperly, derivative instruments result in large losses and make headlines, which thankfully doesn’t happen too often.

The market volatility and associated fears of the economic impact of COVID-19 in March and April 2020 was a time that illustrated how the improper use of derivatives can lead to issues.  Alleged improper derivative management has led to multiple lawsuits, as a result of these strategies having been marketed to institutional investors including corporate and public pension plans.

Where investors have found trouble with certain derivative strategies is when they are not simple, are seeking enhanced returns, and/or are difficult to quantify (i.e. not transparent). Many of the strategies that had large losses earlier this year were referred to as return enhancement strategies.

In these strategies, the managers were trying to earn alpha or extra return by taking the risk that markets would not rise or fall by very much. This kind of return generation strategy has a similar risk/return profile to writing catastrophe insurance (earn a premium if nothing happens, pay out a lot if something does): you have a high probability of earning a little, and a low probability of losing a lot. The problem comes when the amount of potential losses and circumstances under which large losses can occur are poorly understood.    

Based on information in the public domain, it looks like investors in some of the funds that had large losses (80%+ losses in some cases) did not fully appreciate or understand the risks they were taking. It appears that the funds were doubling up on risk: if equity markets went down, the funds would lose because they were invested in equities. But in addition, investors were exposed to large losses if equity markets went down significantly and quickly.  When equity markets went up or even if they went down, so long as the gains or losses were within boundaries, then investors would outperform a passive equity investment.   

The courts will help to determine whether these strategies as marketed were misleading.  It may be that the investors merely heard what they wanted to hear. However, the basic fact remains: using derivative strategies to double down on risks that are already inherent to institutional investing, and doing so in a way that is neither simple nor transparent, can be a dangerous strategy.  It is important to keep in mind though, that it is the strategy that can be dangerous, not the tools that are used.

This is why it is fundamentally important to have transparency when using derivatives.  Too often, we see investors favoring investments that use derivatives inside of funds, rather than using customized derivative overlays. In some cases, investors may wish to avoid perceived operational and decision-making complexity – they just want someone to “do it for them.” However, as recent fund blow-ups have shown, there can be a big disconnect between what an investor thinks they are getting and what a manager thinks it is delivering.

Investors who use customized derivative overlays where the risks are explicit and transparent can have a big advantage. For example, they know exactly what their outcome will be at maturity if they hold their derivative position. In a market where asset prices are moving dramatically, having a degree of certainty as to what something will be worth, say, in one year if markets are flat or up / down 15% can be quite useful. This helps investors avoid making panicked selling decisions. For example, assume you hold a derivative that provides protection for the first 20% of equity market losses at maturity, which is in 9 months. The market is currently down 30%. You have certainty that if the markets stay where they are through the end of the 9 month period, that your derivative will be worth 20%, such that your net loss is only 10%, even with the market down 30%. Having the knowledge that you have “time value” in a derivative like this can influence decisions on rebalancing or portfolio allocation and can help an investor have a more aggressive, vs. defensive, mindset when markets are stressed.

As long as the derivatives are used thoughtfully with the potential outcomes explicitly known, there should be no concern about any of the issues that have plagued so many funds that used derivatives over the years. A strategic derivatives overlay is also just that: strategic. A manager is not trying to add alpha by trading it – it is in the portfolio because it provides efficient exposure to an explicit risk. This is why many institutions use derivatives in their day-to-day operations (e.g. airlines, banks, energy companies). The derivative strategy does what it says on the label.

In summary, derivatives are just a tool. When used appropriately, they can be used to provide investors with the ability to significantly increase the efficiency of their portfolios. When used inappropriately they can add excessive leverage, sometimes unknowingly, and to allow managers to take risks that perhaps they shouldn’t. Too often we’ve seen investment products that have pretty track records with high Sharpe ratios that look great until, suddenly, they don’t. March 2020 was that “suddenly” for a number of funds. There will likely be more similar stories in the future. It is the job of investors and their consultants to work out how derivatives can be used appropriately and avoid situations where they can be misused. It is worth the time to understand how these tools work and to consider whether customized, strategic use of them can be both more efficient and safer than many of the “low risk” strategies marketed by fund managers today.

Questions?  Contact the authors below.

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