Derivatives often part of fund managers' toolkits

A full discussion of how derivatives work could fill a book, but for investors curious to learn more about what they are and how some funds use them, here's a primer.

Defining derivatives

The term "derivatives" refers to financial instruments that derive their value from an underlying asset, such as equities, bonds, commodities or real estate. Some types of derivatives, such as options and futures, might already be familiar to you. These, along with swaps, are among the most commonly used types of derivatives in the financial world. Here are some basic definitions and examples of these three commonly used derivative types.

Futures: Agreement between two parties to buy/sell an asset at some point in the future at a price that is determined today. Although originally developed for use in trading commodities, today commodity futures make up just a fraction of futures traded. Other types include equity index (such as the S&P 500) and even interest-rate futures.

Sample uses: A farmer locks in a high price today for crops he will sell at a later date; an airline locks in future jet fuel prices today to guard against potential price increases at a later time.

Options: Gives its owner the right to buy or sell an asset at a given price for a set time period. Because the option represents the right to purchase the asset and not ownership of the asset itself, it typically costs just a fraction of the asset's price. These instruments may be used to gain exposure to equities, ETFs, equity indexes and commodities. Options come in many varieties and can be used as part of many different trading strategies, such as betting that the price of an asset will go up or that it will go down.

Sample uses: An investor wants to hedge against price swings in a security he or she already owns (covered call); an investor wants to help protect his or her portfolio by buying some downside exposure in case of a market downturn (protective put).

Swaps: Agreement between two parties to trade different payment types over a given time period. These may be used to swap interest-rate or currency exposure, or credit protection (credit default swap).

Sample uses: A bank looking to reduce its exposure to floating interest rates paid on deposit accounts swaps that exposure with another party that can provide exposure to a fixed rate; companies operating in different countries swap currency exposures as a way to reduce currency risk.

Widely used among funds

Mutual funds may use derivatives as a way to gain, hedge or short exposure to a certain type of asset, often at a cost that is lower than it would take to own the position outright. It's hard to gauge the extent to which mutual funds in Canada use derivatives, since the data is not collected systematically. However, the legal environment regarding their use has been getting more and more liberal in recent years, so it's something to look for when you're consulting the prospectus of a fund you're considering buying.

Derivatives used by bond funds include index and currency futures and forwards, options on bond indexes and currencies, and interest-rate and credit default swaps. Stock funds, on the other hand, are more likely to use equity index and currency futures and forwards and options on indexes and individual equities. Alternative Strategies funds tend to be heavy users of derivatives -- for example, trading futures and options as part of a long-short equity strategy.

As an example of how a fund might use derivatives, let's look at   Horizons Enhanced Income Equity ETF  HEX, an actively managed large-cap Canadian equity ETF that holds an equal-weight portfolio of about 30 stocks, with a little bit of extra income thrown in. Along with holding the stocks in the same proportions, the fund's manager sells call options on all these stocks. While this limits their upside potential, the income premiums collected from the sale of the options contracts allow the manager to boost the fund's income distributions.

Use of derivatives also is built into the DNA of so-called leveraged ETFs, which rely on them to execute some rather exotic trading strategies in some cases. Take for example Horizons BetaPro S&P/TSX 60 Bear+ ETF HXD, which is designed to deliver twice the inverse daily return of the S&P/TSX 60 Index. On days when the index is down, the fund aims to deliver a positive return, times two. And on days when the index is up, the fund will have big losses. The ETF pursues its objectives exclusively through the use of derivatives such as futures and swaps, without holding any of the index's underlying securities. (An ETF like this also illustrates the potential risks of such a leveraged strategy in that a sizable gain in the index would result in a loss twice as large for investors. It should only be used by high-frequency traders and those hedging against or anticipating a near-term drop in the index.)

In our fund asset-allocation data, Morningstar treats derivative positions based on the exposure they provide to the underlying asset. So stock futures would be counted in the percentage of assets held in stocks, bond options in the percentage held in bonds, and so on. (Long/short/net exposure to various asset classes is also provided.)

The use of derivatives by some funds makes knowing how your fund works that much more important. Used properly, they can help manage risk and foster innovative investing strategies. But used irresponsibly, they can court disaster. As an investor, you owe it to yourself to understand how your fund works and whether derivatives are part of its approach. And if your fund company is less-than-forthcoming with this information, you have every right to demand it.