Stunned by Your Traditional Bond Fund Delivering Stupendous Returns? Well Don't Be!
Mutual funds are increasingly making use of Derivatives in its portfolio as a strategy to boost the returns from investment. Peruse your Fund's portfolio in the monthly and quarterly fact sheets to ascertain the exposure that your fund has taken in these Derivatives. Comparing these across periods will reveal the extent of churning that your fund manager dolls out in these funds.
Greater Quantum of Derivatives augments the returns and amplifies the risk of your portfolio. The strategy endorsed by the portfolio manager may be Conservative or Aggressive. A Conservative Strategy reduces federal taxes but may also constrict short-term returns. Aggressive churning on the other hand increases the Federal Tax but collates greater short-term returns. Furthermore, derivatives are more effective in flat markets vs. volatile markets.
These Derivatives are usually one of the three types-
1) Credit default swaps
2) Covered Calls
3) Index tracking Derivatives
A Credit Default swap is fashioned to transfer credit exposure of Fixed Income Products amongst parties through Credit Risk Insurance. The buyer of the insurance receives credit protection and the seller guarantees it. These swaps are not regulated by the Securities and Exchange Commission and are not traded on any exchange. This is why they are postulated as riskier instruments as their degree of risk is indiscernible. These swaps provide trading opportunities and are often thriftier options than Corporate Bonds.
A covered call strategy generally refers to a combination of a share and its short call. A call option gives the option holder the right but not the obligation to buy the stock at a particular price. By shorting the call the option holder trades the upside potential of the stock for the stock premium. The price of the share less the premium paid for the option determines the profit or loss per share.
Index tracking Derivatives are the least risky from all the aforementioned options. Many Fund Managers assume responsibility to track a particular Index and in order to match or outperform the benchmark Index, takes on positions in Index Derivatives such as futures and options. While these may bring on additional returns they also are accompanied by preponderant levels of Risk.
Risk from Derivatives is therefore subject to the kind of instruments held in one's portfolio. Index tracking derivatives are less risky as compared to credit swaps. Covered calls could also be very risky. Your portfolio may hold these derivatives in varied permutations and combinations. The risk is therefore, essentially inherent in the quantum and type of instrument held.
With the market providing ample opportunities to accouter additional returns, and with investors biased towards return generating portfolio's, the use of these derivatives can only increase over time.