Sunday, April 23, 2006


Derivatives and Hedge Funds


Derivatives have long been the proverbial "black sheep" of finance. A few highly publicized losses and it's off to the races with bad headlines galore. Don't get me wrong. I'm neither an advocate nor a critic. Like many others, I believe that the decision to use derivative instruments (type, strategy, application) depends on a multitude of factors, starting with an organization's objectives and constraints.

There is no perfect investment or financial technique. Something that works for one company or government may be wholly inappropriate for another. That's why a recent article about hedge funds and derivatives has me puzzled. While I agree that more and better disclosure is paramount, I'm not sure anyone is better off by being scared in the absence of evidence.

Here are a few things to ponder.

1. A $270 trillion derivatives market did not grow by leaps and bounds because these instruments are considered dangerous by all market participants. Someone has to think there are benefits associated with their use.

2. It's possible to create examples that show how the identical derivative instrument and/or strategy can reduce risk in one situation while inducing risk in a second situation. Context is everything.

3. Not all hedge funds hedge. Indeed, some of them employ derivatives in a speculative fashion as a way to try to enhance return. Others use derivatives to reduce interest rate, currency, equity and/or commodity risk.

4. Investors should not plunk down hard-earned money without doing their homework. This applies to institutional investors as well. Pension funds commit billions of dollars to hedge funds every year. Beneficiaries and regulators want to assure themselves that pension investment fiduciaries are doing what is needed to make a well-informed decision about hedge funds, whether they use derivatives or not.

5. Fraud is a tragic reality. Both buyers and sellers need to work together to preserve financial market integrity and make it as hard as possible for bad players to ruin things for everyone else. If this were easy, it would have been done by now. Industry associations and providers of fiduciary education can help.
posted by Susan Mangiero at 4/23/2006 08:09:00 PM