From the June 2007 issue of Wealth Manager Web • Subscribe!

OTC Derivatives

Financial advisors can no longer ignore OTC derivatives, even if they want to. Almost all hedge funds use them, and derivatives have spread into mutual funds as well.

No bond manager today can ignore credit default swaps, contracts in which one party hands over cash in exchange for a guarantee that the recipient will make good at par if a bond issuer goes bust. In effect, credit default swaps represent insurance against a bond issuer's failure to pay.

For conservative, value-based investment management firms such as Lord Abbett, swaps present an opportunity to enhance the yield on fixed income portfolios, according to Milton Ezrati, the firm's senior economic and market strategist. But while Lord Abbett sometimes sells credit default swaps against its bond portfolios, it will do so only to the extent it owns the bonds, and if the price offers an attractive premium relative to the risk. "A bank could take the other side of a credit default swap for regulatory reasons, and we would be paid quite a premium for relatively little risk," Ezrati says. The strategy, akin to covered writing of options, does not violate either the spirit or the letter of his firm's long-only mandates.

Lord Abbett occasionally uses currency derivatives in its global portfolios. If it likes a foreign market, but not its currency, it will buy the market and hedge all or part of the currency exposure. The firm can use derivatives to alter the duration of its bond portfolios, too. Although Ezrati does not expect derivatives ever to play a big role at Lord Abbett, he says the firm will expand their use as liquidity improves. "The last thing we want to do is get involved in a market with so little liquidity we can't trade our way out of it," he explains.

It was the lack of liquidity in natural gas contracts that accentuated the losses at Amaranth, the latest in a trail of disasters related to OTC derivatives stretching back at least to the Orange County, Calif. fiasco in 1994. Every so often, an organization incurs eye-popping losses because it did not understand the risk it had assumed--and this in a market that exists to transfer risk. OTC derivatives keep growing by leaps and bounds, however, and only a handful of participants have gotten into serious trouble. For the vast majority of players, these customized contracts have proved to be a cost-effective risk management tool.

Markets in derivatives--whether exchange traded or OTC-- shuffle gains and losses among participants, but neither create nor destroy wealth in the aggregate. It's a zero-sum game: For every long position, somebody else has to be willing to go short. The situation differs from real asset markets, where investors are net long the value of those assets, whether they be stocks, bonds, real estate or something else. Sellers (other than short sellers) own the asset and merely forgo future price movements when they sell; buyers capture that movement and do not depend on shorts to accommodate their trades.

Although there is no central exchange for OTC derivatives, bond managers sometimes find these contracts offer better liquidity than the underlying cash instruments. Art Steinmetz, head of OppenheimerFunds' international fixed income team and portfolio manager of the $5.4 billion Oppenheimer International Bond Fund, explains how credit default swaps help him manage credit risk.

His fund owns bonds issued by Dell Mexico that are guaranteed by the Mexican Ministry of Education. They pay a "handsome premium" over Mexican government bonds, Steinmetz says, but they are illiquid. Technically, there is no government credit risk--the Ministry of Finance stands behind Mexico's sovereign debt--but Steinmetz reckons it's almost as good. If he turns bearish on Mexico, he can buy credit default swaps to reduce his country exposure without having to sell the Dell Mexico bonds which, he admits, would be difficult. "I would not be comfortable buying Dell Mexico if I couldn't change my mind about it," he says, "Credit default swaps allow me to reach out to lower liquidity paper to pick up yield and still have the ability to change my mind."

Steinmetz also uses derivatives to manage duration. If he believes interest rates are likely to fall, the fund's investment policy permits him to extend duration by up to 20 percent from his benchmark. Before derivatives came along, he had to sell short-term bonds and buy longer maturities to move the portfolio duration from say, five years to six. Now, he can buy treasury futures or enter into an interest rate swap contract to achieve the same result. "Derivatives often have lower transaction costs, higher liquidity and more transparency than trading a whole bunch of cash bonds," Steinmetz says.

Illiquidity pervades many areas of the fixed income markets--including U.S. investment-grade corporate bonds, the focus of the T. Rowe Price New Income Fund. Portfolio manager Dan Shackelford will use derivatives provided that the flexibility they offer benefits fund shareholders. "If we sell cash bonds outright, we may never find the same bonds to buy back when we want them again," he says. If he has temporary reservations about a credit, he prefers to keep the bonds and hedge the exposure with a credit default swap.

T. Rowe Price takes a cautious approach, sticking to standardized derivatives contracts that have already gained acceptance in the market. The firm recognizes that it needs infrastructure in place to handle counterparty risk and contract administration as well as the expertise to manage portfolio risks. "We are going to make sure that the risk component and the operational component go hand in hand," says Shackelford, "We'll do it on our timeframe and won't let the market dictate that to us."

Shackelford suggests that financial advisors should be wary of mutual funds that trumpet their expertise in using derivatives for portfolio risk management, but don't talk about operational controls. The mutual fund world is accustomed to delivery versus payment, but OTC derivatives contracts incorporate margin provisions and periodic post-contract payments between counterparties. A single fund complex could have relationships with many broker/dealers, acting, in effect, as separate exchanges for contracts to which they are a counterparty. "They are your lifeline," says Shackelford, "You have to keep track of what you are owed, what they owe you, and make sure payments are made in a timely way."

Most OTC derivatives are best left to hedge funds, according to Jim Baird, chief investment strategist in the Kalamazoo, Mich. office of Plante Moran Financial Advisors, a $5 billion Midwestern firm. For clients who invest in hedge funds, Baird recommends funds of funds to guard against the risk of an individual fund blowing up. He draws an analogy to investors who held Standard & Poor's 500 index funds five years ago when Enron and WorldCom collapsed. "You still take that indirect loss, but it's mitigated because you have a broadly diversified portfolio," says Baird.

Funds of funds, he believes, also are better placed than financial advisors to pick hedge funds. "Even if we wanted to pursue investments in individual hedge funds, do we have the critical mass to be able to dig into the details the way a major fund of hedge funds company might?" Baird asks. In effect, investors outsource the selection of individual hedge funds, so Baird concentrates on identifying funds of funds that have reliable due diligence processes.

Whether it's a hedge fund or a mutual fund, Baird stresses that investors need to understand how derivatives contracts fit into the investment strategy. After all, a contract used to manage risk in one context can provide leveraged exposure in another. He wants to be sure that funds deliver good performance and follow their stated investment guidelines so that the investment fulfils its intended purpose in a client's portfolio.

Scott Welch, managing director of Rockville, Md.-based Fortigent LLC, which provides "business to business" wealth management services to banks and RIAs, first encountered OTC derivatives after tax law changes in 1997 put an end to selling short against the box, the traditional strategy for managing the disposal of a concentrated stock position. As the next best thing that still passed muster with the Internal Revenue Service, Wall Street came up with option collars--long a put and short a call--and variable prepaid equity forwards, which set a minimum sale price, but let the investor keep part of any upside and take some cash up front without selling the stock at once. Those products made up Welch's primary application of OTC derivatives from 1997 through 2003.

In 2003, Congress lowered the tax rate on capital gains and qualified dividends, but dividends on hedged stock positions were excluded. Companies had an incentive to increase their dividends, too. The economics shifted overnight. In most cases, hedging became an unnecessary complication; investors were better off selling the stock, paying the tax and moving on. "You could make a reasonable argument that taxes in the U.S. are never going to be lower than they are today," says Welch.

The wirehouse brokers who used to handle his hedging trades have mostly switched over to structured products desks. For individual investors, notes that offer exposure to hedge funds and principal protection have proved popular among those who were burned in the bear market. Welch is skeptical, though, and suspects that investors do not understand the risks involved--or how much money the issuing banks skim off. He sees implicit leverage in these products that isn't captured by conventional measures of risk because the outcome is not normally distributed. "I try not to sell anything that people don't understand," he says, "If my clients can't explain it back to me, then they probably shouldn't be doing it."

For occasions when financial advisors still use OTC derivatives to hedge concentrated stock positions, Jason Taylor, chief investment officer at Threshold Group, a $1.44 billion wealth management firm in Gig Harbor, Wash., recommends soliciting multiple bids. He favors options collars. The dealers get details of the stock, the size, a floor price and a desired term for the agreement, and then offer different ceilings for the upside participation. Taylor finds the spread between best and worst can be surprisingly wide. "You can really be taken if you don't play one dealer against the other," he says. Threshold doesn't talk to derivative dealers directly, however; it goes through Twenty-First Securities, a New York broker that specializes in these trades.

When clients want to invest in hedge funds, Threshold's due diligence covers how the fund uses derivatives, how contracts are priced, who the counterparties are and the concentration of risk at individual counterparties. The Amaranth blow-up has only reinforced Taylor's belief that in-depth due diligence is the best protection his firm can offer clients. "We have been saying that for a while, but it takes this type of event to underscore the value that we add," he says.

Neil A. O'Hara is a financial writer with intimate knowledge of domestic and international markets from a previous career in money management. A native of England, he and his wife reside in Lincoln, Mass.

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