Economics Essay: Funds and derivatives

Funds and Derivatives

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
" 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]
Yahoo Finance, Mutual Fund 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.)