Derivatives can lessen risk or add to it


Popcorn sold in movies, Mexican and Chinese food, margarine.

Seems they're always discovering something new that's supposedly bad for us.

This year's financial addition to that blacklist has been the derivative. Just as many Americans don't know what they're eating, others don't know what they're investing in. Judging from the letters received by this column that are concerned about derivatives, it's time for everyone to become an informed investor.

Derivatives are financial arrangements whose prices are derived from prices of stocks, bonds, currencies or other underlying markets. In a positive sense, the price relationships between derivatives and the underlying securities can provide flexibility in managing risks.

This year, it was suddenly discovered that some derivatives products can also be very bad for you. Many plummeted in value with the steep increases in interest rates, taking a big bite out of mutual funds that held them. Portfolio managers, it turned out, had been quietly but aggressively using derivatives to boost returns in the period of declining interest rates.

Infected with the derivative bug were some money-market funds and short-term bond funds that had been sold to average investors as safe choices. They'd included in their portfolios the most risky interest rate-vulnerable derivatives, such as collateralized mortgage obligations created out of bundles of mortgages and the securities derived from them.

"There's been an arms race to create more exotic, esoteric derivative securities, with firms carving up securities and then getting exotic with the leftovers that hadn't been put together with much forethought," said Stephen Savage, editor of the Value Line Mutual Fund Survey. "But you can now expect to see a slowdown in creation of new derivatives."

In the first legal action by the half-dozen prominent companies to disclose derivatives losses, Gibson Greetings sued Bankers Trust Co., accusing it of "deception, cheating and fraud" in derivatives transactions that cost Gibson $19.7 million.

Big financial firms such as PaineWebber, BankAmerica, CS First Boston, Piper-Jaffray and Fleet Financial have bailed out funds to the tune of hundreds of millions of dollars to shore up asset value, avoid investor lawsuits and stave off extensive government regulation.

"A derivative is like a handgun, for it's not so much the derivative but how it is used," said John Markese, president of the American Association of Individual Investors. "Using a derivative to reduce risk is a practical benefit, but speculating to pick up yields based on assumptions about interest rates shouldn't be done."

A survey by the Investment Company Institute found that 475 mutual funds with net assets of $350 billion recently held derivatives. About two-thirds of those assets were in bond funds. Total market value of all these derivatives was $7.5 billion, or 2 percent of the total net assets of all funds that reported they held derivatives.

Most investors and, remarkably, even most experts didn't have a clue about what was going on.

"Investors must be aggressive with brokers, registered representatives or other intermediaries, asking directly whether a fund invests in derivatives," advised Barry Barbash, director of investment management at the Securities and Exchange Commission.

"In terms of regulation, we're looking at improving the disclosure of instruments so you can tell whether certain ones are derivatives, and a more difficult task would be coming up with a form of risk rating."

Issues raised by funds holding derivatives include whether the derivatives will become illiquid and whether they're being valued appropriately, he said.

"In almost all cases, the derivatives are included in the prospectus, yet it is a statement of permission, not commission, and fund managers may not make use of everything they're permitted to use," explained A. Michael Lipper, president of Lipper Analytical Services.

Be sure to ask these questions of all mutual funds:

* What has been the fund's long-term track record? Pay particular attention to the average annual returns over the past three years and quarterly volatility.

* What are the initial sales charges, redemption fees and expenses of the fund?

* How long has the current portfolio manager been in charge?

* Are there special risks involved in the fund? Get details on whether it uses options, futures or derivatives, and whether such instruments are used for hedging or for speculative purposes.

A less risky type of derivative used to reduce volatility can be a good inclusion in a portfolio. Be certain of what you're getting when you invest.

"If you see 10 funds in a category in which nine are yielding 3.6 percent and the 10th is yielding 5.2 percent, I'd be skeptical about what is going on with that last fund," warned Martin Jaffee, president-elect of the International Association for Financial Planning.

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