Traditionally, mutual funds mainly invest in basic assets, such as stocks, bonds or money market instruments, but so far, derivatives have in turn had a huge reaction to the price of basic securities. Therefore, mutual funds can no longer ignore the existence of financial derivatives, and pay more and more attention to the specific role of grafted derivatives in investment management strategies.
Three ways to use financial derivatives
Hedging The purpose of hedging is to control the price risk of assets. Orange farmers can lock in the actual transaction price in the future through forward or futures trading before oranges are ripe, and at the same time avoid the risk that prices may fall in the future. Mutual funds can take similar actions to protect their portfolios from rising interest rates, falling stock prices or currency depreciation by using certain financial derivatives.
Of course, financial derivatives have their own prices and price risks. For example, the fund manager of a stock fund thinks that the stock market may fall in the future, and can hedge the risk of stock spot positions by establishing short positions in stock index futures. When the stock market does not actually fall or even rise, there will be losses in futures positions, and the investment performance of the fund will be worse than when there is no hedging.
Some investors may think that if fund managers think the market will fall, they should sell stocks instead of hedging. This is a misunderstanding. The motivation of fund managers to hedge risks is to protect the present value of portfolio and avoid uncertainty, including upward and downward value changes, and the cost of hedging operation is the necessary cost. If the market rises against its expectation, it can quickly close the derivative position, restore the spot position and enjoy the spot market income.
If you choose to invest in oranges, it may be easier to buy a security (such as orange juice futures) than an orange orchard. Mutual funds can take this approach. For example, when there is a large amount of cash to subscribe for the fund in a short period of time, the fund manager can first buy index futures representing a package of stocks or bonds, instead of all the stocks or bonds included in the index. Doing so can also minimize the high transaction costs brought by a large number of short-term entry into the spot market.
Speculation The use of speculation is to directly profit from financial derivatives, which is similar to "gambling" in a sense. Take an orange farmer as an example. If he sells oranges twice as much as his output in a forward or futures contract, and hopes that the price of oranges will fall on the actual delivery date, so as to realize low purchase and high sale, then he has evolved from a hedge trader to a speculative trader. If the price of oranges rises sharply at that time, he will suffer huge losses, which will be further amplified by the leverage of derivatives trading.
The three ways in which mutual funds use financial derivatives are mainly concentrated in the first two ways, namely, asset preservation, liquidity management and cost reduction through appropriate operations, which ultimately benefit fund holders.
The regulatory thinking is loose first and then tight.
Judging from the supervision of financial derivatives on mutual funds, the development of practice has dominated the evolution of different supervision concepts. The great development of financial derivatives in the United States was after 1970s, so what are the main laws and regulations to adjust the legal relationship of mutual funds? The Investment Company Law and Investment Consultant Company Law of 1940 have no relevant provisions on mutual funds investing in financial derivatives, but there are strict restrictions on mutual funds selling stocks, which are quite different from hedge funds with more freedom of operation.
From 1970s to 1997, the dominant idea of American regulators was short selling of mutual funds and liberalization of the use of financial derivatives. After 1997, especially after the long-term capital management company (LTCM) incident broke out in 1998, the supervision of financial derivatives began to strengthen. On May 13, 2004, the Federal Reserve System, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Savings Supervision Bureau and the Monetary Authority issued the famous Joint Statement on Reasonable Operation of Structured Financial Behavior, focusing on the internal control and risk management of financial institutions participating in structured financial behavior (i.e. financial derivatives). Although the regulatory authorities do not clearly stipulate how mutual funds use financial derivatives in law, it is required that fund management companies should fully disclose whether and how to invest in financial derivatives in the fund prospectus, so that fund holders can judge the risks and benefits of the fund and decide whether to invest.
Generally speaking, mutual funds do not use financial derivatives to a large extent. According to the statistics of American Morningstar Company, the average investment portfolio of bond funds is 5% invested in derivatives, while that of stock funds is only 1%, and a few funds have reached the level of 15%. Of course, different fund products and different market conditions are different. Relatively speaking, international funds and special equity funds use financial derivatives more widely, because these two types of funds usually face greater investment risks. However, when the financial market is in great turmoil, such as the Asian financial crisis in August, 1998, financial derivatives are also used by more mutual funds, mainly to control the risk of sudden sharp rise.
Many empirical studies show that the use of financial derivatives can not bring obvious investment return effect to mutual funds, but it has obvious risk control effect. The American Association of Investment Companies has a classic expression: "There is no inherent problem in the use of financial derivatives by mutual funds. If used properly, it will be a valuable investment management tool and bring significant benefits to fund holders. "