Does the mutual fund you invest in use derivatives? A derivative is a contract that is valued based on the value of something else. Examples of derivatives include:
• Futures Contracts
• Options
• Stock market indices
• Interest Rates
• Currency exchange rates
Derivatives have legitimate roles in conservative money management:
- They can be used as insurance against currency fluctuations when investing dollars in investments that are denominated in foreign currencies
- They can be used as insurance against large sudden drops in the value of the funds investments.
- They can be used by a fund that is seeking to be 100% invested in stocks to maintain exposure to stocks while keeping some of their assets in cash. This tactic reduces trading-related expenses.
On the other hand, derivatives can be used to leverage or magnify a fund’s exposure to fluctuations in the value of an investment. For example, the Comex division of the New York Mercantile Exchange offers a futures contract that, with an initial margin deposit of about $5500 in cash or securities, you can be exposed to the fluctuations in value of 100 ounces of gold (in 2008 that was over $80,000). If the price of gold went up or down by $10 in one day, you would gain or lose $1000, which would be an 18% move compared to your deposit, which you would pay or collect the next morning in cash. Compare that with buying $80,000 of gold, in which case you would see only a 1.25% fluctuation. On the other hand, if there was a $60 drop in the price of gold, you would actually lose $6000 in one day, which is more than your original $5500 deposit.
How does your fund use derivatives?
The prospectus or marketing literature for your fund is required to disclose whether the fund uses derivatives, to what degree, and for what purposes. As described above, there are many legitimate, cost-reducing, and risk-reducing uses of derivatives, but if your fund uses derivatives as leverage, be aware that this will make your investment riskier.
Beta - a Measure of Risk
One test for the risk level of a stock fund is its beta, which is a measure of how much the fund’s value fluctuates compared with the general stock market. A fund with a beta of 2.0 fluctuates twice as much as the overall stock market, and a fund with a beta of 0.5 fluctuates half as much as the overall stock market. If you are looking for less risk, you will look for an investment with a beta that is less than one, though it means you will be less likely to participate in stock market advances. With risk comes the possibility of larger gains and larger losses. The key is to limit your risk to a level that is tolerable and consistent with your investment goals.
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