Many mutual funds may contain “derivatives” in addition to purchasing stocks, bonds, and other securities. Understanding how a fund uses derivatives, the types of derivatives used, and how those derivatives are reported may be important to evaluating that mutual fund. The following information is important to understand as you review and evaluate the information provided for each mutual fund reported on our website.
- What are “derivatives”?
- Derivatives are financial contracts whose values depend on or are derived from, the value of an underlying asset, reference rate or return, or index (for example, the S&P 500), and may relate to stocks, bonds, interest rates, currencies or currency exchange rates, and indexes comprised of these types of assets. Examples of derivative instruments include options, futures, forward currency contracts, options on futures contracts, and swap agreements.
- Why are derivatives used in investment portfolios?
- Derivatives can be used for multiple purposes, such as to reduce risk (hedging), lower costs (such as transaction costs), and to potentially increase returns. Which derivatives are used and how they are used may depend on the investment manager’s objectives and strategy.
- What is meant by “short positions” and what is meant by “long positions”?
- This is an important concept to understand. “Long” positions in derivatives are positions whose values move in the same direction as the prices of the underlying investments, pools of investments, indexes or currencies. “Short” positions are those whose values move in the opposite direction from the prices of the underlying investments, pools of investments, indexes or currencies.
- Do derivatives present additional risks?
- Derivative instruments involve risks different from and possibly greater than the risk associated with investing directly in securities and other instruments. There can be no guarantee that derivative strategies will work, that the instruments necessary to implement these strategies will be available or that the Fund will not lose money. Derivatives involve costs and can be volatile. In addition, any derivatives that the Fund invests in may not perform as expected and this could result in losses to the Fund that would not otherwise have occurred. The use of derivative instruments may also include: counterparty risk, which is the risk that the other party to the derivative contract may not fulfill its obligations; liquidity risk, which is the risk that a particular derivative instrument may be difficult to purchase or sell; interest rate risk, which is the risk that certain derivative instruments are more sensitive to interest rate changes and market price fluctuations; valuation risk, which is the risk of mispricing or improper valuation of the derivative instrument and the inability of the derivative to correlate in value with its underlying asset, reference rate or index; and the risk that suitable derivative transactions may not be available in all circ*mstances for risk management or for other purposes. The fund’s investment in derivatives may involve a small investment relative to the amount of risk assumed. For example, for some derivatives, it is possible for the fund to lose substantially more than the amount it invested in the derivative instrument. To the extent the fund enters into these transactions, their success will depend on the manager’s ability to predict market movements.
- How can derivatives be used to seek to reduce risk in a portfolio?
- Two examples of common uses of derivatives to reduce risk are “duration” (sensitivity to interest rate changes) management for bond funds and currency management for international funds. Bond fund managers may buy a portfolio of individual bonds that they believe are attractively priced in the market, but that as a group have a longer duration than the manager believes is appropriate given then current market conditions. The manager may decide to adjust the portfolio’s duration through the use of derivatives, without having to buy or sell individual bond holdings. International fund managers who purchase securities, fixed income as well as equity securities, with foreign currency exposure may decide to manage currency risk through the use of derivative currency contracts.
- How does the use of derivatives by a fund impact the fund’s reported portfolio Characteristics?
- Derivatives differ from traditional stock and bond holdings in many ways. One important difference is that derivatives may impact the performance of a portfolio in a proportion that is larger than the amount of money actually expended to invest in the derivative contract. In other words, some derivatives may permit a portfolio to commit a relatively small amount of cash relative to the value of assets to which the derivative is linked. For example, for some stock futures contracts the amount of cash required to be invested initially is often about 5% of the principal or “notional” amount of the contract. That is unlike a traditional stock investment for which the amount of cash invested in the stock is the same, at the date of purchase, as the value of stock purchased. As a result, reporting characteristics, such as portfolio statistics, top holdings, distribution of assets across classes and sectors, for portfolios using derivatives is made more complicated. For example, some industry participants and data reporting services calculate certain characteristics using the principal or notional value of derivatives, while other characteristics are calculated using the value of the cash committed to purchase the contract, plus any subsequently required payments. That difference in accounting may significantly impact the characteristics reported.
- Also, for some characteristics, such as sector distribution, some industry participants may “look through” the derivative contracts to the underlying securities. For example, a fund holding stocks in addition to equity index futures contracts may calculate the total fund’s sector distribution by considering the individual stocks composing the index on which the futures contract is based in addition to the shares of stock held by the fund.
- An additional example of portfolio characteristics reporting complexity results from how short derivative positions may be reported. In some situations industry participants and reporting agencies may report the value of short positions by adding these positions to the value of other assets in determining the total portfolio value to use as the basis for characteristics calculations. In other situations the short positions are “offset” or subtracted from the value of other portfolio holdings.
- The above examples of the added reporting complexity accompanying the use of derivatives is not exhaustive, but highlights some of the important characteristics reporting differences for portfolios using derivatives.
- What methodologies does MissionSquare use to report characteristics for funds using derivatives?
- For The Vantagepoint Funds equity mutual funds, MissionSquare relies on information from the Fund’s custodian JP Morgan Chase, from investment subadvisers, as well as Morningstar data, subject to corrections of apparent errors or incomplete information. For The Vantagepoint Funds fixed income funds, MissionSquare uses a third party software system operated within MissionSquare, information from investment subadvisers, the Funds’ custodian JP Morgan Chase, and Morningstar information. For funds reported by MissionSquare, other than The Vantagepoint Funds, MissionSquare relies on data provided by Morningstar.
