Active managers are understandably keen to use any available weapon to fight the rise of passive investing, and in financial markets weapons don’t come more fearsome than derivatives. In 2003, Warren Buffett declared ‘derivatives are financial weapons of mass destruction.’
Buffett was speaking principally about a book of unwanted derivatives that came with his purchase of Gen Re, so it’s not entirely fair to contrast his past assertion with his subsequent extensive use of put options. He is not alone in having embraced derivatives, though.
In a new paper, Paul Calluzzo, Fabio Moneta and Selim Topaloglu of the Smith School of Business at Queen’s University in Canada document the trend among a sample of 4,793 US domestic-equity funds. They excluded index products and vehicles with less than $5 million of assets, and focused on the use of three types of complex instruments: options, leverage and shorts.
Using the funds’ N-SAR filings with the Securities and Exchange Commission (SEC), they reported that between 1999 and 2015 the proportion of these funds permitted to employ all three varieties of derivative leapt from 25.7% to 62.6%. Almost all, 99.2%, were allowed to use at least one of the complex techniques.
Not all acted on this discretion. In fact, very few did: only 17.3% of the full sample used derivatives in 2015. The authors noted some cyclicality in their deployment too: there was a marked decline after 2008, for example. Yet looking at the full period, 42.5% of the funds did use a complex instrument at least once.
That’ll cost you
The more interesting question addressed by Calluzzo, Moneta and Topaloglu was whether funds that did utilize derivatives could demonstrate the value of doing so. Broadly, they couldn't.
Funds that used leverage, shorting or options were associated with lower annualized excess returns and alpha in the subsequent six months, although not all of the relationships were statistically significant.
One exception was that funds that wrote options did deliver positive and statistically significant alpha, which the academics supposed was a result of the income generated by selling options.
The wider underperformance could be tolerable if investors were compensated for lower returns by a lower risk profile, but that was not the case either.
Moreover, managers appeared to take false comfort from complex instruments, as those who used them were shown to take greater risks in their underlying equity holdings. The paper framed this as a moral-hazard problem: positions viewed as hedges give superficial license to own more volatile stocks.
Derivatives were valuable to fund managers in a different sense, however. The study indicated that using at least one of the three complex instruments was associated with a 0.072% annual increase in a fund’s net expense ratio. The use of shorts and options yielded the greatest fee premium, but the connection between leverage and expenses was insignificant.
Even leaving aside whether derivatives were actually used by a fund, products that did not have such permissions had, on average, fees that were 0.19% lower than those allowed to take complex positions. Funds that could but did not use derivatives were also 0.07% cheaper than those that did.
Hedge funds for the masses
‘Overall, it appears mutual fund investors are better off choosing simplicity,’ concluded Calluzzo, Moneta and Topaloglu.
‘The question remains, if these funds underperform, why do they exist in equilibrium? One explanation is that these funds cater to an investor bias towards complexity. This bias may be reinforced by SEC regulations that restrict retail investors who earn less than $200,000 a year or have less than $1 million net worth from investing in hedge funds. Investors may think accessing complex hedge fund-like investment strategies facilitates outperformance. This explanation is consistent with our finding that complex instrument use is more common in funds held predominantly by retail investors.’