WSJ: Mutual Funds Add Exotic Fare to the Mix

Many Are Making Increasing Use of Complex Derivatives
To Enhance Performance, but the Strategies Carry Risks

By ELEANOR LAISE
April 4, 2007; Page D1

Mutual funds are increasingly using complex financial products called derivatives to hedge their bets or boost their returns -- and that's raising concerns among regulators and fund watchdogs.

Institutional investors such as hedge funds have long used derivatives, which include options, futures, swaps and other, more exotic fare. But now these instruments are increasingly appearing in ordinary diversified stock and bond funds that often serve as core holdings for small investors.

ON THE HEDGE

Fund managers are making increasing use of financial derivatives. Here are some popular strategies:

• Covered-call options, often used to generate a steady stream of income.

• Credit-default swaps, popular with bond funds looking to add or subtract credit risk. These instruments are relatively untested.

• Index tracking, often with the aim of amplifying index performance -- upward, but also downward.

Major fund companies like Eaton Vance Corp., Federated Investors Inc. and Rydex Investments have recently launched funds that rely heavily on derivatives as a core strategy. Established bond mutual funds, including some offered by Fidelity Investments and Amvescap PLC's AIM Investments, are increasingly making use of a relatively new and untested type of credit derivative. And a flood of derivatives-heavy exchange-traded funds began appearing early last year, after long-awaited regulatory approval of these vehicles.

Funds' use of derivatives -- which Warren Buffett once called "financial weapons of mass destruction" -- is growing as the instruments become easier to trade and as mutual funds aim to stand out in a crowded field. More automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds. And with more than 8,000 mutual funds on the market, many managers believe it's not enough to match a market index. They want to beat the market -- and derivatives often help.

While many newer, more-exotic mutual funds plainly advertise their derivatives strategies, the instruments may play an equally important, but less obvious, role in some plain-vanilla funds. The AIM Income and Fidelity Investment Grade Bond funds, for example, have been around for decades and, at first glance, may look like straightforward bond portfolios. But as of the end of February, the Fidelity fund had invested about 18% of its assets in futures, options and swaps, while roughly 70% of the AIM fund's assets were in derivatives.

Derivatives can be used to boost returns, increase yield, get access to more-exotic asset classes like commodities or simply reduce risk. Indeed, many types of derivative-heavy funds thrived in recent years amid relatively placid markets. But in recent weeks, as markets have gyrated more wildly, the vulnerability of some of these funds has become more apparent.

Many of these funds use an options strategy that generally works best in relatively flat markets, not one that's moving sharply up or down. And some funds that use derivatives to produce returns that are a multiple of a selected market index saw sharp declines during the recent broad market downturn.

Another concern: Many funds that employ derivatives strategies can hit fund investors with hefty tax bills, since these funds tend to trade often and can generate more short-term capital gains.

At the same time, the people responsible for overseeing mutual funds are raising concerns about derivatives. "I am not trying to say that funds should not invest in these instruments, but I am saying that you should do a lot of work up front before you wade into uncharted territory," said Securities and Exchange Commission investment-management division head Andrew Donohue last week, addressing a mutual-fund industry group, noting that "funds very often are newcomers" to derivative and other sophisticated instruments.

In recent months, fund auditors have raised questions about the accounting methods for a complex derivative called an "inverse floater" often used by municipal-bond funds. The questions prompted many of these funds, including some offered by OppenheimerFunds and Eaton Vance, to revise their financial statements for the past several years. The funds say the changes don't affect investors' returns. But the issue raises broader questions for some in the industry.

"We were all blindsided by the inverse floaters," says Dorothy Berry, a director for Professionally Managed Portfolios and Allegiant Funds who serves on the governing council of the Independent Directors Council, a group of mutual-fund directors. "That raised the specter of 'What else is out there?' You've got to be aware of how [derivatives] are valued and how they're being used."

A fund's prospectus tells investors whether a manager may use derivatives and how they may be used. Funds' quarterly holdings reports also include any derivative investments. These reports can be found at www.sec.gov/edgar.shtml¹ and are often posted on fund companies' Web sites.

Here are some of the fastest-growing derivatives strategies and how they might help -- or hurt -- your fund's performance.

Covered-call options. So-called "covered-call writing" or "buy-write" funds make up a rash of new income-oriented stock funds. These funds typically sell call options on stocks they hold or on a stock index. By selling a call option, a fund agrees to sell a certain stock at a set price before a set date. Selling calls provides a steady stream of income -- a feature that has proven popular as baby boomers approach retirement and as low interest rates have left investors hungry for yield.

One fund that sells index call options, Eaton Vance Tax-Managed Global Diversified Equity Income, became the biggest U.S. closed-end fund initial public offering in history when it was launched in February. Other new closed-end funds that sell call options include Nicholas-Applegate Equity & Convertible Income, also launched in February, and BlackRock Preferred and Equity Advantage Trust, launched in December. (A closed-end fund resembles a traditional mutual fund but has a fixed number of shares that typically trade on an exchange.)

But recent market volatility means a mixed bag for covered-call writing strategies. On one hand, higher volatility generally means higher options prices, which could benefit the funds. And if stocks head south, the option income offers some limited cushion, but there's not much insurance against a major downturn. But if stocks move up sharply, these funds could give up substantial upside as their stocks get called away.

Rampart Investment Management Co., which manages covered-call writing funds for Eaton Vance, is considering adding more downside protection to its funds through put options and other derivatives, partly because of the recent change in market conditions, says president and CEO Ronald Egalka. "Just recently risk has again become a four-letter word, and people are not quite as sanguine about the market looking forward," Mr. Egalka says.

Credit-default swaps. One of the fastest-growing types of derivatives, the credit-default swap, is rapidly gaining fans among bond-fund managers. A credit-default swap is essentially a form of insurance against a company or country defaulting on debt. The swap buyer typically pays a quarterly fee to the seller, and the seller agrees to make a payment to the swap buyer in the event of a default. A significant market in the swaps has existed for less than 10 years.

Many fund managers like credit-default swaps because they can be easier and cheaper to trade than regular corporate bonds and offer an easy way to add or subtract credit risk. Several AIM bond funds, including AIM Income and AIM Total Return Bond, recently used CDSs for the first time, buying a CDS index that includes 125 corporate bonds. The Federated Real Return Bond Fund, launched late last year, can invest up to 80% of assets in CDSs.

But as the CDS market has exploded, many questions have been raised about their risks. The swaps, which typically don't trade on an exchange, are often simply agreements between a fund and a Wall Street firm. In late 2005, as CDS trading accelerated, regulators met with major Wall Street dealers to discuss backlogs of unconfirmed trades and other problems in the credit derivatives market.

Funds must also be concerned with the possibility that the banks selling the swaps won't be able hold up their end of the deal. And questions have also been raised about market manipulation. A 2005 study by researchers at the London Business School found evidence of possible insider trading in CDSs. Timothy Johnson, a co-author of the study who is now an associate finance professor at University of Illinois at Urbana-Champaign, says the market is still "the wild west."

The instruments raise questions for some fund managers. In a commentary posted on its Web site in December, bond-fund giant Pimco noted, "Innovation is a wonderful thing, but it can also lead to excesses that separate asset prices from their underlying value, whether we are talking about houses, corporate bonds, credit-default swaps or pets.com."

Tracking indexes. Many funds use derivatives to track a market index. Some, like Pimco StocksPlus, are relatively conservative. The fund aims to outperform the S&P 500 by investing a small slice of the portfolio in index derivatives contracts and the bulk of assets in bonds. But many new index-focused funds are more exotic -- using derivatives to double index returns or to track commodity prices. And many of these funds are difficult to use properly in a portfolio, analysts say.

The U.S. Oil Fund, launched early last year, aims to track changes in the price of West Texas Intermediate light, sweet crude oil, as measured by changes in the price of oil futures contracts. But oil futures contracts can behave quite differently than the actual price of oil. In the first three months of this year, the fund was up 3.4%, while West Texas Intermediate crude oil was up nearly 8%. Manager Nicholas Gerber says the fund is "doing a great job" of tracking its benchmark futures contract. Since the U.S. Oil Fund is structured as a limited partnership, not a mutual fund, investors receive a K-1 partnership income tax form, which can complicate individual investors' tax returns.

Recent market conditions have highlighted the risks of leveraged index funds, which often use derivatives to magnify the performance of a market index. The Direxion S&P 500 Bull 2.5x Fund, for example, uses derivatives as part of its strategy to deliver 250% of the daily performance of the S&P 500, before fees. During the market downturn of Feb. 27, when the S&P fell about 3.5%, the fund fell nearly 9%.

And because of the way leverage compounds over time, investors can't always expect a fund that aims to double index returns on a daily basis to double the index returns over the long haul. ProFund Advisors LLC, a company that manages leveraged index funds, warns investors on its Web site, "returns for periods longer than one day often do not reflect the daily investment objective."

Reginald Laing, an analyst at investment-research firm Morningstar Inc., calls the funds "a fairly gimmicky idea" that "doesn't make sense for the vast majority of investors."