Funds' Increasing Use of Derivatives Raises Concern

Regulators and fund watchdogs are keeping their eye on mutual funds that are increasingly using complex products such as derivatives to boost returns, according to the Chicago Tribune.

Derivatives have been used by hedge funds for a long time, but now they are appearing in ordinary diversified stock and bond funds that often serve as core holdings for small investors.

Eaton Vance Corp., Federated Investors and Rydex Investments recently launched funds that rely on derivatives as a core strategy.

Warren Buffett once called derivatives “financial weapons of mass destruction,” and the use of them is growing as they become easier to trade and mutual funds look to distinguish themselves.

Also a concern is that many funds that use derivatives strategies can hit fund investors with large tax bills, since the funds usually trade often and can generate more short-term capital gains.

Additionally, regulators have concerns about the product. “I am not trying to say that funds should not invest in these instruments, but I am saying that you should do a lot of work up front before you wade into uncharted territory,” said Andrew Donohue, director of the division of investment management at the Securities and Exchange Commission, at the Investment Company Institute “Mutual Fund and Investment Management” conference in Palm Desert, Calif., last month.