Investment Management Association

Facts about funds

Derivatives

Investment managers use derivatives to manage the risk in the funds and portfolios they are managing, to give them greater flexibility, to reduce dealing costs and to enhance returns. To do so, they must have the necessary professional skills and follow strict regulations. Derivatives are financial instruments that derive their value from underlying assets, such as shares or bonds, or from other things, such as interest rates, currencies or market indices. They give investment managers an efficient means to gain exposure to, or to hedge against, changes in the value of the underlying investments.

You can find out how a fund is using derivatives by reading the fund's documents or by asking an investment adviser.

Use of derivatives in funds

They can be used to:

Manage risk
Provide greater flexibility and to lower costs
To generate investment returns.

Manage risk

Derivatives have been used to manage uncertainty (i.e. reduce risk - a process called hedging) and cost for investors in funds for many years. More investment managers are now using derivatives specifically to meet the investment objectives of the fund i.e. derivatives are not used to reduce financial risk but to potentially profit from it. In each case, the process is subject to strict regulation, and managers using derivatives must have a robust risk management framework to monitor and measure the risks in the fund's portfolio.

Investment managers may ‘hedge’ certain investments or transactions to ensure they are not taking unnecessary risks which investors in the funds are not expecting. Derivatives enable managers of internationally invested funds, for example, to offset the risk of a currency movement that might undermine the sterling value of the fund.

The term ‘hedge’ should not be confused with ‘hedge funds’, which are not authorised investment funds and which can use sophisticated financial instruments more freely and may invest borrowed money to boost returns, making them higher risk.

Greater flexibility and lower costs

Derivatives can be easier to buy and sell than the underlying holdings. They are useful tools for investment managers of funds with large or illiquid share holdings, or tracker funds, which need to change their portfolio mix very regularly in line with the index. For example, when a manager wishes to sell a share holding and ensure that the fund is not exposed to a fall in the market price due to a lack of immediate buyers, then a derivative can be used to effect the sale, and to give the manager certainty about the sale price and time to sell the shares gradually. This process is a form of Efficient Portfolio Management.

Generate investment returns

Investment managers are increasingly including the use of derivatives in their strategies to meet funds' investment objectives. In doing so, they must have an advanced system to measure the risks and to ensure they are not exceeding the regulatory limits on a daily basis.

Managers may hold a derivative of a stock market index, for example, instead of holding shares or bonds directly to get the same potential return.

They can also use derivatives to 'short' an index, or bonds or shares, and so potentially enhance returns in a market where prices are falling. Regulations prevent authorised funds from physically selling shares short on a purely speculative basis. Collateral must be arranged with a counterparty and the amount of exposure to any one counterparty is strictly limited.