by Don Alexander, MBA
Associate, RSD Solutions Inc.
The recent losses by JP Morgan Chase on their hedging portfolio again raise questions about the use of derivatives and the risk profile they may create. While we do not know the exact strategy they implemented, the positions they were hedging, or the risk profile created by the derivatives, it does raise questions about the use of complex derivatives and their risk management.
One place to look at the application of complex derivative strategies in their impact upon hedge funds and their potential benefit to investors. A recent working paper by Jarkko Peltomaki called Do Investors Really Need Complex Derivative Strategies? The author investigates the benefits of using a more complex derivative strategy in relation to their performance and risk characteristics from a sample of hedge funds and funds of hedge funds. The results of the study suggest that the use of a complex derivative strategy may increase the probability of suffering large losses and expose investors to weaker performance.
Earlier studies suggest that with mutual funds, the use of derivatives does not improve fund performance. In this study, the use of a complex derivative strategy may actually have a negative impact on the performance of hedge funds. However, there was a negative relationship between complex derivative strategies and performance of funds of funds. This suggests that a good risk management system may prove a benefit to investors.
The author suggests that derivative strategies employed by hedge funds may be related to “hidden risks” due to larger tail distribution of returns. This risk is more difficult to find in funds of funds since the use of derivatives has the opposite effect to that of complexity. It may be the use of complexity and not just the use of derivatives which is associated with hidden risk in the returns of funds of funds.
Peltomaki notes that there is a difference in the origin of hidden risks between hedge funds and fund of funds. For hedge funds, the risk is hidden in their exposures to market based factors while funds of funds risk are hidden in idiosyncratic returns. Hedge funds take risk using market based factors following herding behavior that may serve to mitigate the difference in their relative performance. Funds of funds are limited in their exposure to hedge funds and their hidden risks are more related fund-specific exposures. Regulators need to be concerned about hidden risks used in derivative strategies used by hedge funds since they may have a more systemic feature.
Is JP Morgan Chase a large hedge fund or fund of funds – more disclosure may tell? The lessons that we can draw from the JP Morgan Chase experience is that complex derivative strategies may not have a favorable benefit for investors and make increase their exposure to systemic risk. The key lesson is simple derivative strategies combined with good risk management produce better outcomes and reduce exposure to hidden risks.
What is your derivative exposure? Is it overly complex with hidden risks?
For more on this follow the link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344656
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