The Use of Derivatives by Investment Managers and Implications for Portfolio Performance and Risk^*

Abstract

This study provides an empirical examination of derivative instruments used by institutional investors. Our analysis provides a unique insight into the role and benefits of derivative securities in active equity portfolio management. We contribute to the literature by using a database that comprises the periodic portfolio holdings and daily trades of institutional fund managers. The consequence of derivative use is analyzed using a number of performance and risk measures. Overall, we find the use of derivatives have a negligible impact on fund returns, and is primarily attributed to low levels of derivative exposure relative to total fund size. We also evaluate how derivatives are used by considering the trading strategies executed by active investment managers. Specifically, option trading patterns are consistent with the execution of momentum trading strategies. This study also documents that active investment managers prefer not to use options markets to engage in informed trading.

Do Derivatives Have a Role in the Risk-Shifting Behaviour of Fund Managers?

“…However, over the entire sample period there are no significant differences between derivative users and non-users. These results are consistent with Koski andPontiff (1999), Fong, Gallagher andNg (2005) and Pinnuck (2004) who find no significant differences in risk and performance measures between users and nonusers of derivatives. (1) where ∆ RISK is the change in the risk variable between the first six-months and the second six-months in a year.…”

“…The performance, risk and turnover for option users are not significantly different to non-users. Fong, Gallagher and Ng (2005) examine institutional funds and find no difference between users and non-users of derivatives in terms of their performance and risk characteristics. Their results show that options are used to gain exposure to momentum stocks.…”

Equity Funds and Derivatives: Evidence from Linked Fund-Trade Data

“…Hitherto, the literature had to rely on rather low-frequency reporting data. In this way, we can complement previous evidence on which types of derivatives equity funds use (e.g., Fong, Gallagher and Ng, 2005;Cao, Ghysels and Hatheway, 2011;Cici and Palacios, 2015;Natter et al, 2016;Benz et al, 2019).…”

Derivative use, fund flows and investment manager performance

“…All mutual funds that use derivatives are aggregated into a single group and effectively no distinction is made between different types of derivative trading strategies. This broad classification method is also employed in studies of derivative use by investment managers in the UK (Fletcher et al, 2002), in Canada (Johnson and Yu, 2004) and Australia (Fong et al, 2005;Pinnuck, 2004). As such the analyses contained in Koski and Pontiff, as well as these other studies, are only able to provide insight into 'average' derivative trading behaviour.…”