If even professionals can stumble on derivatives, it’s no wonder small investors are nervous. And they have company. Securities and Exchange Commission head Arthur Levitt last week wrote to mutual-fund chiefs, urging them to invest cautiously. Rep. Edward Markey has asked the SEC to consider revising fund rules.
There’s no need for panic. Only about a fourth of funds in a recent survey reported trading in derivatives, says John Collins of the Investment Company Institute. And most use them in limited amounts to balance other investments, protecting them against big shifts in the market. They’re “like the family dog that protects the house,” Collins says.
But if a fund manager is imprudent, the pets can “show their fangs,” he adds. And you may not notice till you’ve been bitten. It’s not easy to figure out your exposure, but a good place to start is the fund’s prospectus. Check the section on investment strategy, where it says what the fund can and can’t invest in, and watch for buzzwords like “strip securities” or “inverse floaters.” If your eyes glaze over, pick up a phone. Your broker or fund company should tell you if the fund includes derivatives, what percentage of assets they are and how they’re used. If you don’t like what you hear, get out.
