Demystifying derivatives
Executive summary:
- Derivatives are financial contracts between two or more parties that are based on the performance of an underlying asset or index.
- Derivatives can be used to hedge extreme market selloffs, exposure gaps between assets and liabilities, changes in interest rates or inflation expectations, the future price of commodities, the risk of missing out on a rally, and a host of other investor concerns.
- Derivatives are complex financial instruments with associated risks, costs, and potential payoffs. Because of this, we believe it’s critical to work with an investment solutions provider that has extensive experiencing using them responsibly.
One fear that I’ve heard repeatedly since I first started trading stock options as a teenager is that derivatives are scary. This is, no doubt, thanks to the many scandals, abuse, and misapplication captured in the headlines. A specter of danger often hovers over derivative instruments, like when Warren Buffett famously described them as “financial weapons of mass destruction.” So, are derivatives inherently scary or are they like most things we buy nowadays—accompanied with disclaimers and directions about responsible usage?
Fear of derivatives is easy to understand. Perhaps it’s their quality of not existing in the physical world like a stock or a bond. Or maybe it’s their enduring nature in which as soon as one expires, there’s another one to take its place. And let’s not forget their amazing ability to hedge or gain exposure to some asset without spending the money to do so. All of this may conjure up thoughts of some sort of Frankensteinian synthetic instrument. But as tends to be the case with many origin stories, derivatives are simpler than they first appear.
Must use responsibly
Most of the history of derivative contracts involves farmers and food buyers who wanted to insure against crop failure, hedge the risk of price changes, or secure the supply of goods. Hedges occurred on all sorts of goods like wheat, cattle, and metals. The same concept was eventually applied to interest rates, currencies, and stock indices.
Like any powerful tool, a derivative should only be used with care. It’s not advisable to use them without knowing their risks, costs, and benefits. Russell Investments has been using derivatives responsibly since 1986. In overlay services, nearly all derivative-based solutions are for hedging purposes. We use derivatives to hedge the risk of cash being a drag on performance. We hedge the risk that overweight asset class exposures will decline in value (or vice versa for underweight asset classes). Derivatives can be used to hedge extreme market selloffs, exposure gaps between assets and liabilities, changes in interest rates or inflation expectations, the future price of commodities, the risk of missing out on a rally, and a host of other investor concerns.
The bottom line
There’s often a stigma surrounding derivatives as they can attract both the risk averse farmer and the reckless investor. Only one of these users makes the news. And despite Warren Buffett’s foreboding comment about derivatives, he still uses them. A lot. Another misconception is that many investors think derivatives are new, and therefore, unfamiliar and risky. Contrary to popular belief, these are no longer new and innovative instruments. They were considered cutting edge 3,700 years ago—long before physical currencies and stock markets. Thankfully, most institutional investors have now recognized their advantages to hedge risks and enhance returns—and have implemented thoughtful guidelines for overlay programs, fixed income mandates, LDI completion solutions, and specialized hedges. But they are indeed powerful tools, so we believe it’s critical to partner with a firm that has extensive history in their responsible usage.