A type of flexibility common to many absolute return strategies is the ability to use modern investment tools such as derivatives, including forwards, futures, and option contracts. A trained, professional money manager can use these tools to gain exposure to specific markets, to fine-tune portfolio strategies, and to mitigate unwanted market risks.
What is a derivative? Broadly speaking, a derivative is any type of investment whose value is linked to the performance of another security. Futures, forwards, and options are among the most commonly used derivatives.
Futures and forward contracts: These contracts are agreements to buy or to sell something in a specified quantity and for a specified price on a future date. As the prices of the contracts change, it provides an indication of where investors think prices are headed. These contracts are typically used for either speculative or hedging purposes. Futures or forward contracts may be used to obtain exposure to an investment and profit if the price moves as expected. In hedging strategies, almost the exact opposite occurs - the contract is used to lock in a certain price in the future, and thereby remove the uncertainty involved in the price movement. Forward contracts are also heavily used to establish positions in currencies, while futures contracts are common tools for gaining exposure to stock indexes and bonds, such as Treasuries.
Options contracts: These contracts provide exposure to future prices, instead of creating an obligation, they give the buyer or seller the right to purchase or sell securities at a certain price within a specified period of time. A put option is the right to sell a security, while a call option is the right to purchase a security.
What is the function of derivatives in an absolute return portfolio? For the purpose of an absolute return strategy, an attractive feature of forwards, futures, and options is the ability to reduce risk by hedging against specific concerns, such as interest-rate movements or credit defaults, or against broad market declines. In particular, by using put options on market indexes, an investor can build in a buffer against market declines. That is because a put option becomes more valuable when the underlying security or index approaches or falls below the put option's strike price.
Derivatives can be used for many purposes to help funds perform more independently of overall market direction. They also allow investment managers to implement their views about which securities, sectors, or markets are likely to appreciate and depreciate. With this tool, investment managers can more comprehensively capture their overall investment view in a portfolio, and not be limited to long exposures only.
While derivatives can be a very valuable tool, it is important to remember that they are not a cure-all that eliminates market declines.
- Using derivatives effectively requires analytical and forecasting skills similar to those used in selecting securities. As such, not every decision made with derivatives will help a strategy.
- Because derivatives give investors a great deal of leeway, they can also have an outsized impact on performance, but they can represent a risk to performance if used incorrectly.
- Trading derivatives involves investment costs that can reduce performance. While highly specialized and aggressive strategies rely on extensive use of derivatives, for most investors, a prudent, judicious approach to derivatives is most effective.