How many funds have invested in derivatives
in the years 1995-2001, and in what types of financial derivatives
contracts(options, futures, swaps, forwards or other derivatives)? What does the fund use derivatives for?
(that means they use derivatives as risk management tools
and so on)
In this part of the research, we are looking into the funds
in the UK All Companies category to find out the use of derivatives
in managing these funds .The fund category restricts the investment
process to use the inter asset class hedging or the intra
asset class overseas hedging to only 20 percent or less. This
has left the asset managers to hedge mostly within the same
asset class with the same sector exposures .The possibility
of using the derivatives for hedging purposes are thus reduced
heavily in this case. Here we are looking into the funds that
may or may not have used derivatives in this UK all companies
category during the time span of 1995-2001 .We have found
out 201 funds fall in this category, for the lack of data
for that specific period, we are looking into the set of funds
that started before that period and still continuing and existed
for the period between 1995-2001 .We are looking into the
pattern of returns for these funds and short listed the top
ten funds in this category that with the assumption that the
best funds are the most well managed and will show the effect
of the derivatives used in case of the fund managers used
them in those funds .UK All Companies
The 'UK All Companies' funds are those funds that have invested
at least eighty percent of their assets in the listed UK equities
and have the primary objective of obtaining capital growth
by managing funds within the equity asset class. The UK All
companies' funds can be divided into subsections of [1]
" Ethically Managed funds
" Index Tracker funds
" Actively managed funds.
Here in our discussion we are concentrating on the third
form of the 'UK All companies Fund ' that is the actively
managed fund the other funds do not engage in active management
so the question of using the derivatives do not arise. We
are looking into the hedging processes used in these actively
managed funds through various financial derivatives contracts
(options, futures, swaps, forwards or other derivatives) and
how these active management has affected the returns of these
funds.
Here we have used FTSE 100 as the benchmark index for our
research and to measure the effectiveness of all these hedging
processes with the index movements over the five-year period.
We will also look into the comparison of the top ten performers
in this sectors and compare them with the performance with
the benchmark index to see how the hedging process has worked
and where they may have gone wrong. We assume that any investor
investing into index funds do not manage his portfolio within
this period of five years and the returns generated by these
index funds indicates the return that can be achieved to inactive
funds management.
The top ten funds according to the performances
in the five years [2]
1
Rathbone Special Situations
54.
38 %
2
Fidelity Special Situations
38.70 %
3
Solus UK Special Situation
34.34 %
4
St James's Pl UK & Gen Pro(Closed
Fund)
19.35 %
5
Marlborough UK Equity Growth
18.31 %
6
Investec UK Performance A
8.50 %
7
Merrill Lynch UK Value Inc
7.55 %
8
Cavendish Opportunities
4.23 %
9
Schroder Inst Recovery
2.31 %
10
Investec UK Value Inc
-1.91 %
The return of the FTSE 100 benchmark during this period is
-30%[3].
Among the 201 funds in this category, 169 funds
have performed better than the FTSE 100 index [4].
The funds had invested atlas eighty percent (80 %) [5]
of their funds in the UK equities that is represented by the
index and hence can be said to have the same universe of equities
to choose from as the index. Looking into this we can say
that the actively managed funds in the UK All Companies category
have out performed the index.
To analyse the use of derivatives and the usefulness of the
derivative instruments form the risk - return perspective,
we can say, the changing trends in the 1980's in maintaining
the capital value of the mutual funds had led to the higher
risk adjusted returns, greater portfolio diversifications
and more protection from the risks associated with the end
of the bull markets during the period as the streamlined investment
strategies lost the edge to produce market-plus returns. This
had led to the new form of asset management where we use different
strategies like using options, swaps, futures, forwards and
other financial instruments to actively manage the investment
to get better returns [6].
As we have seen in the returns of the portfolios during the
past years where the funds have on an average have performed
better than the market as represented by the index. Managers
of these actively managed funds seek to add value to the funds
by using the skill-based strategies.
The underlying principle
of this active management is the rejection of the traditional
investment paradigms like the efficient market hypothesis
or the modern portfolio theories that assume that the stock
prices include and exhibit all the information's through the
prices. The Actively managed funds work with the assertion
that the markets do not price all the assets correctly. Therefore,
they set up specific strategies to exploits these inefficiencies.
They attempt to build strategies based on futures, options,
forwards to exploit these market inefficiencies[7].
When we analyse the funds in the allocation
process to understand the management process in hedging used
by the managers. The entire asset management is done through
the management of stocks into different sectors and in different
companies within particular sectors. Looking at the table,
we can say allocating assets in four different sectors does
the process: Financials, Services, Retail & Cyclical stocks
[8].
Fund
Asset Classes & Holdings in %
Top 3 Sectors
C=Cash, S=Stocks, B=Bonds, O=Others
Rathbone Special Situations
C: 3.4,S: 96.6
F,S,C
Fidelity Special situations
C:1.1S :98.9
F,S,R
Solus UK special Situation
C:.6,S:99.4
F,C,S
Marlborough UK Equity Growth
C:4.7,S:91.8,B:1.3, O:2.2
F,R,C
Investec UK Performance A
C:4.8,S:95.2
F,S,R
Merrill Lynch UK Value Inc
C:12.3, S:87.7
F,S,E
Investec UK Value Inc
C:4.6, S:95.6
F,S,E
Schroder Inst Recovery
S:100%
F,S,E
Crest Suisse Growth fund
C:1.4,S:98.6
F,S,E
Cavendish Opportunities
C:.2,S:99.8
S,C,T
S=Services, E: Energy
R=Retail, F: Financials, C: Cyclical
T: Technology
The top ten mutual funds in the UK All Companies Sector and
their exposure to derivatives.
( We have replaced the St James's Fund with Credit Suisse
Growth Fund 11th in the list of returns , as the St James's
fund has been closed )
Fund: Rathbone Special situations:
Holding Pattern: 120 stocks with less that 10% exposure in
offshore investments. Less than 3% of investment in any organization.
Management Process:
Finding under-valued companies with good management and proven
record of performance .The fund focuses on companies that
are less affected by the general economic conditions. No use
of derivative products stated in the process.
No Derivatives
Fund: Fidelity Special Situation Fund
Holding Pattern :Investments only in small-cap and mid-cap
companies .The company actively manages portfolio within the
UK equities and the cash .The universe for this fund is FTSE
all share index.
Management of the fund: The fund's long-term performance success
has been
Based on manager Bolton's consistent bottom-up, value driven
approach. Although the style has provided occasional periods
of relative underperformance when pure growth stocks have
surged ahead,
Special Situations has one of the very best 20-year track
records in this or any other unit trust sector .The fund is
managed within the equities and no exposure to derivatives.
No Derivatives
Fund: Marlborough UK Equity Growth Holding Pattern: The Company invests in the British
companies only .The fund invests in small companies with capacity
for rapid developments in the future and large organizations
with good growth potential because of the macroeconomic conditions.
Fund Objective:Growth in capital
Management of the fund:
The funds are managed in an optimum way so that units in the
trust qualify for investment in both an ISA and a PEP No use
of derivatives in the fund management.
No Derivatives
Fund: Solus UK Special Situations
Holding Pattern: The fund invests heavily in the financials
and new economy stocks and balances the exposure with investments
in defensive stocks that are traditionally less volatile.
Management Pattern: The organization actively manages the
funds between the cyclicals; underperformers with growth potential
and can outperform the markets in the future. The financials
are overweight in this fund and no use of derivatives to manage
the fund.
No Derivatives.
Fund: Merrill Lynch UK Value Fund
Holding Pattern: The investments done in high beta
holdings along with cyclicals in the upward trend .the fund
also invests in underperformers with strong past records and
with the potential to outperform.
Management of the fund: Active management of the stocks
on future expectations and recreation of the portfolios in
an aggressive way. The fund uses derivative products for the
active management of the fund. The fund does not invest in
the sector specific way, it is more towards investing in individual
organization and takes a boarder approach towards fund managements.
Used derivatives Options and futures
Fund : Investec UK Performance A
Holding Pattern: Investments in the shares of companies
in the UK considered to be "special situations"
and believed by the manager to offer above average opportunities
for capital gain through outperforming the market. Management of the Fund: Active management through restructuring
of the portfolio by introducing the growth stocks .The continuous
change in the portfolio takes place without using the derivatives
in recreation of the portfolio .
No Derivatives.
Fund: Investec UK Value Inc
Holding Pattern: The fund invests actively into the
value stocks that are stable over a period and gives a stable
return. Management of the fund: The fund is actively managed
within the value stocks .The fund aims at long term capital
growth and does not focus on short term speculative performances.
The fund is exposed heavily in the UK All Company's category
and draws from the companies with a history of good performances.
No derivatives
Fund: Schroder Inst Recovery
Fund Holding Pattern: The fund invests into various
asset classes and changes it's holding according to market
situation. Traditionally the holding move between the equities
from the UK companies and the fixed income securities.
Management of the Fund: The fund moves between the
fixed income and the equities and within the UK All company's
category and used derivatives to manage the funds. The prolonged
weakness of equities relative to bonds and the likely long
term out performance of equities over bonds could make now
a particularly poor time to implement the move out of equities.
Used derivative: Options
Fund: Cavendish Opportunities Rtl
Fund Holding Pattern: The Cavendish Asset Management
opportunities fund invests in smaller companies but do switch
into the cyclical to get the benefits in times of recovery
or in cyclical stocks. Fund also invests actively in underperformers
with a potential to show positive retunes.
Management of the Fund: The company uses the derivatives
to maintain its risk - return objective for the funds, the
non- rigidity of this fund is shown in its broad holdings
and the shifts in the sector weights. The Opportunities Fund
has the ability to move between different sectors as market
conditions change; smaller companies offering strong long-term
growth, companies offering recovery prospects, and companies
in market sectors that are depressed.
Used derivatives: Options
Fund: Credit Suisse Growth Fund
Fund Holding Pattern: The fund follows the pattern
of the other UK All company's mutual fund pattern. The fund
also exposes itself to overseas markets within the limits
to enhance the returns. The fund managers believe it is an
environment to have a balanced portfolio of perceived 'old'
and 'new' economy stocks and look closely at valuations.
Management of the Fund: To maximise the total return
to investors over the years. The Fund's investment policy
is to follow a medium to low risk strategy. The emphasis of
the Fund will normally be on equities but from time to time
significant proportions may be invested in fixed interest
securities. And the fund uses the derivatives extensively
for the management of the funds.
Use of derivatives in the Mutual funds
The use of derivatives in equity mutual funs can be attributed
to there factors namely ,
" Funds that invest in derivatives may have lower risk
than the funds that do not invest into derivatives.
" Managers investing into derivatives to manage the equity
mutual funds may improve the net portfolio performance either
due to lower transaction cost or better utilization of the
information.
" Managers can affect the intertemporal changes in the
funds's risk exposure , for example to respond to investors
redemption patterns or the purchase patterns . Analysing the
pattern of the trades of the investors the fund managers can
use the derivatives to create the cash flow patterns to meet
the cash flow demand arising in various times. [9]
Here in our research we have looked into the funds into the
UK All companies Sector.
We have analysed the top 10 funds
in this category to look into the effect of derivatives on
fund performance. Looking into the fund management of these
funds (excluding the similar funds of the same mutual fund
companies; for example two funds from Investec with same patterns,
so only one fund is taken, and we went to the next fund) out
of the funds analysed only Four of them have some kind of
exposure in the derivatives (Schroder Inst Recovery fund and
Cavendish Opportunities funds, Credit Suisse Growth Fund and
the Merrill Lynch UK Value Funds) and they are the lower rankers
in the top ten leaders in this UK All Companies funds group.
Looking into the allocation pattern within the funds in the
different equity sectors, we can see that the active management
came through identifying the under priced equities in the
small cap and the mid cap sectors in the UK All Companies
mutual funds.
The use of derivatives in this sectors (among
the leaders) did not make a significant impact on the risk
-return scenario of the funds apart from introducing variety
of ways in the fund management. The funds that use derivatives
and that do not use derivatives have almost identical returns
distribution. The usefulness of the derivatives can not be
identified here .The speculative ness of the derivatives in
the mutual funds may introduce higher standard deviation that
may again reduce the risk reduction effect expected through
the introduction of the derivatives product. The most preferred
form of derivatives is options.
The Risk -Return profile of the top funds in UK All
Companies
Fund
Morningstar Rating
Fund Category
Mean Return
Standard Deviation
Sharpe Ratio
Beta
Rathbone Special Situations
UK Equity Small Cap
6.55
18.16%
0.19
0.7
Fidelity Special Situations
UK Equity Mid Cap
5.6
19.42%
0.15
0.87
Solus UK Special Situation
Solus UK Special Situation
-16.99
23.45%
-0.86
0.89
Marlborough UK Equity Growth
UK Equity Small Cap
-3.21
16.17%
-0.4
0.56
Merrill Lynch UK Value Inc
UK Equity Mid Cap
-1.61
17.96%
-0.25
0.78
Cavendish Opportunities
UK Equity Small Cap
-2.66
24.67%
-0.17
0.99
Investec UK Performance A
UK Equity Large Cap
-9.38
16.94
-0.76
0.87
Investec UK Value Inc
UK Equity Large Cap
-0.72
16.90%
-0.23
0.89
Schroder Inst Recovery
Schroder Inst Recovery
-9.93
17.57%
-0.76
0.97
Crest Suisse Growth fund
UK Equity Large Cap
-8.78
17.01%
-0.72
1.05
Source Morningstar Mutual fund Research:
Data Compiled by the Author.
Inference: Among the top funds in the UK All Companies
category, we can see the return profile is not matched with
the standard deviation of the funds irrespective of the management
of the fund using derivatives or not and the fund category
within the UK All Companies sector. Again the Beta, indicating
the sensitivity of the fund with the market portfolio is not
giving any specific indication about the return profile of
the funds .The effect of derivatives does not show any effect
on the ratings of the funds as the funds using derivatives
do not show any improved rating compared to the non-derivatives
funds .We can say that the use of derivatives in these funds
(within the given sector) does not offer a true chance to
use the complete benefits of derivatives as hedging &
speculation within a particular market can not alter the risk
-return profile to a great extent .
Investment Management Association
Guidebook 2001[Return]
Investment Management Association
UK. Mutual Fund Performance 2001,2002[Return]
Standard & Poor. Mutual
Fund Tracker 2002 -2003[Return]
Financial Services Authority
UK: Guide on Mutual Funds.[Return]
Bookstaber et al, 1981,Options
can alter Portfolio Returns; Journal of Portfolio Management
7,
page 63 -70[Return]
Warther et al, 1995, Aggregate
Mutual fund flows, Journal of Financial Economics 39,
Page 209-235[Return]
Data source Morningstar Research.
Compared and created by the Author . [Return]
Koski et al 1996;how are derivatives
used, Evidence from the Mutual fund industry: Wharton
working Paper 96-27 [Return]
BIBLIOGRAPHY:
Investment Management Association Guidebook 2001
Investment Management Association UK. Mutual Fund
Performance 2001,2002
Standard & Poor. Mutual Fund Tracker 2002 -2003
Yahoo Finance, Mutual Fund 2003.
Financial Services Authority UK: Guide on Mutual
Funds.
Bookstaber et al, 1981,Options can alter Portfolio
Returns; Journal of Portfolio Management 7, page 63 -70
Warther et al, 1995, Aggregate Mutual fund flows,
Journal of Financial Economics 39, Page 209-235
Koski et al 1996;how are derivatives used, Evidence
from the Mutual fund industry: Wharton working Paper 96-27.
Morningstar Mutual Fund Research.
Elton & Grubber 1999: Investments Volume 2: Chapter:
The performance of the Managed Portfolios, The MIT Press.
Page 99-103 (For reference and not quoted in this part
of the research.)
