How are derivatives used in practice by investment managers?

Derivatives can be used as return-enhancing tools or for risk management. They can be used for the purposes of efficient portfolio management (to reduce unnecessary costs) or they can be used in structured products that help the portfolio meet its intended outcomes. Structured products can themselves be risk management devices or return enhancing tools.

On the risk management side there are funds that utilise ‘volatility caps’, ‘variable volatility caps’, ‘constant proportion portfolio insurance (CPPI)’, ‘drawdown breaks’, and other similar tools. Volatility caps typically monitor the ex-ante volatility of the portfolio on a daily basis and if it spikes above a pre-set cap e.g., 15% the volatility cap will sell futures to reduce the overall risk of the portfolio. The strategy is premised on the fact that risk assets often have ‘fat-tailed’ distributions, and the volatility cap can ‘cut off’ the tail avoiding losses. Criticisms are that the volatility cap usually triggers after the initial big drawdown. CPPI and drawdown brakes do something similar but usually measure the extent of drawdown rather than volatility. Criticisms of these are that the portfolio can become trapped in low-risk assets and never recover after the drawdown.

On the return-enhancing side of the portfolio, aside from the use of derivatives as a low cost implementation tool, there are strategies such as call option over-writing and alternative risk premia strategies (ARP). ARP strategies are systematic exploitations of academically observed risk premia within a typical asset class premium, often driven by behavioural factors. These can be directional or market neutral and include strategies such as ‘fixed income relative value’ or ‘volatility carry’. Call option over-writing involves selling call options in combination with owning equities, to enhance income and reduce upside potential.

Derivatives expand the investment managers toolset, allowing for flexibility, responsiveness, and cost reduction. Not all usage of derivatives results in net leverage of the portfolio; that is, usually any implied borrowing as a result of derivative usage is often backed by physically owned safe assets in the portfolio such as government bonds.