As hard as many bank mutual fund executives try to avoid controversy, derivatives and the risk they sometimes carry can cause unpleasant portfolio surprises.

Often maligned and nearly as often poorly understood, derivatives are used by almost a third of investment fund managers to boost returns or reduce investment risk, according to a recent survey commissioned by Ernst & Young, New York.

Some mutual fund executives say the report may actually understate the prevalence of derivatives in portfolios.

"In almost all money market funds, it's tough not to use derivatives," said James L. Kermes, president and chief executive of Glenmede Trust, Philadelphia, and formerly chief investment officer for Northern Trust, Chicago.

Securities as simple as bonds with call provisions or variable- rate demand notes are types of derivatives, explained William D. Dawson, executive vice president, Federated Investors, Pittsburgh, a leading supplier of mutual funds to banks. And these instruments commonly populate bank mutual fund portfolios.

"Derivatives capture an unbelieveably large percentage of the fixed- income world," Mr. Dawson declared.

About three-quarters of bank mutual fund assets are held in money market funds and bond funds, according to data from Lipper Analytical Services.

But derivatives, on their face, shouldn't be alarming, said Ernst & Young partner Steven E. Buller, one of the report's authors.

"People are bashing derivatives, but they play an important role in the management of mutual funds," he said. "Derivatives aren't inherently evil," he added, but they do require adequate management controls.

The remarkable variety of derivatives and their frequent departure from expected market behavior contributes to misunderstanding and complicates their management.

The gain or loss on derivatives is sometimes hard to predict, said Stanley D. Vyner, president HSBC Asset Managment Americas, Inc., which manages the mutual fund portfolios of Marine Midland's Mariner funds.

Groups of derivatives used to hedge positions are often linked. That can make managing individual instruments tricky.

"You can't generalize about a rule for each position," Mr. Vyner said. - "What you can say is that there should be a certain limit for all positions within a group."

Some simple derivatives require little management supervision of trading operations, said Paul A. Brook, partner and specialist in bank mutual funds, Ernst & Young.

Covered call options, under which the owner of a stock sells the future right to purchase shares already in the portfolio, carry little or no risk. Many mutual fund prospectuses allow portfolio managers the flexibility to do this without prior approval or special oversight, he said.

Though some portfolio managers are comfortable managing these derivatives by themselves, they say that regular reporting to the board of directors is critical, and that use of riskier instruments should involve oversight outside the trading operation.

"For futures, or wherever there might be some level of greater risk, clearance by an oversight board might be prudent," said Sterling Jenson, president, First Security Investment Management, portfolio manager for six mutual funds sold by First Security Bank, Salt Lake City.

Rules of thumb for managing derivatives use are hard to come by precisely because of their complexity and variability.

But for esoteric instruments where there may be little or no open market such as structured notes, custom-designed products whose performance depends on an index of other securities, prior board approval is crucial, Mr. Brook said.

"Any security for which you can't get a market price - either bid or asked or last sale - should have some level of board involvement," he declared. "If I'm a board member in today's environment, I want to know ... how it's supposed to work and how it will be valued."

Some investment managers agree. "No board member wants to be surprised" by derivatives problems, said Glenmede's Mr.Kermes.

At Northern Trust he "stress-tested" any use of derivatives in a money market portfolio to make sure it could withstand a one-day swing of 200 basis points in interest rates without breaking a fund's $1 net asset value.

That provided high assurance to the board and investors alike, he said.

His ultimate rule to live by: Don't take big positions in anything, no matter how good you think it is. If derivatives exposure is kept small, everyone sleeps better.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.