Mutual funds may use derivatives as a way to gain, hedge, or short exposure to a certain type of asset, often at a cost that is lower than it would take to own the position outright. Use of derivatives is prevalent across fund categories.
Derivatives used by bond funds included bond index and currency futures and forwards, options on bond indexes and currencies, and interest-rate and credit default swaps. Stock funds, on the other hand, were more likely to use equity index and currency futures and forwards and options on indexes and individual equities. Alternative funds tend to be heavy users of derivatives--for example, trading futures and options as part of a long-short equity strategy.
Let’s take an example of how a fund might use derivatives, focusing on a large-blend equity fund that aims to track the S&P 500, with a little bit of extra return thrown in. Rather than simply seeking to hold all the stocks in the index at the appropriate weightings, as a typical S&P 500 index fund would do, a manager could use futures and swaps to gain exposure to the index and its price changes at a much lower cost. This allows him to invest the fund's large pile of unused cash in short-term bonds in an attempt to boost returns and beat the index.
Use of derivatives also is built into the DNA of so-called leveraged ETFs, which rely on them to execute some rather exotic trading strategies in some cases. ProShares UltraShort QQQ is designed to deliver twice the inverse daily return of the tech-heavy Nasdaq 100 Index. On days when the Nasdaq 100 is down, the fund aims to deliver a positive return, times two. And on days when the index is up, the fund will have big losses. The ETF pursues its objectives exclusively through the use of derivatives such as futures and swaps, without holding any of the index's underlying securities. (An ETF like this also illustrates the potential risks of such a leveraged strategy in that a sizable gain in the index would result in a loss twice as large for investors. It should only be used by high-frequency traders and those hedging against or anticipating a near-term drop in the index.)
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