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Derivatives Do Affect Mutual Funds Returns : How and When?

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  • Charles Cao
  • Eric Ghysels

    ()

  • Frank Hatheway

Abstract

This paper is the first to present evidence on the magnitude of derivative use by mutual funds. Using a unique data set of detailed balance sheet information on open-end mutual funds, we characterize the nature of derivative use by these funds. Most mutual funds using derivatives do so to a very limited extent that has little discernable impact on returns. However, there exist two types of funds that make more extensive use of derivatives, global funds and specialized domestic equity funds. The risk and return characteristics of these two groups of funds are significantly different from funds employing derivatives sparingly or not at all. We find evidence that fund managers time their use of derivatives in response to past returns.Specifically we show that past returns are positively related to derivative use, consistent with the cash flow hypothesis of Lynch-Koski and Pontiff. But we also find that the relationship between derivative use and past returns becomes negative at year end, which is consistent with the managerial incentive hypothesis of Brown, Harlow and Starks and Chevalier and Ellison. Finally, evidence during the financial crisis of August 1998 supports the hypothesis that the effects of derivative use are most pronounced during periods of extreme movement although there is no evidence in derivative use of managers' market ex ante timing ability. Cet article est le premier à analyser l ampleur de l utilisation des produits dérivés par les fonds communs de placement. En utilisant une banque de données exclusive de bilans de transactions sur les fonds communs de placement, nous caractérisons la nature de l utilisation des produits dérivés par ces fonds. La plupart des fonds communs de placement qui utilisent des dérivés le font à un degré si limité que cela a peu d'impact sur les rendements. Cependant, il existe deux types de fonds mutuels qui se servent plus intensément des produits dérivés : les fonds globaux et des fonds d actions domestiques spécialisés. Les caractéristiques de risque et de rendement de ces deux groupes de fonds sont sensiblement différents de celles des fonds utilisant parcimonieusement ou pas du tout les produits dérivés. Nos résultats montrent que les gestionnaires de fonds utilisent des produits dérivés en réponse aux rendements passés. Plus spécifiquement, nous montrons que les rendements passés sont positivement liés à l'utilisation des dérivés, ce qui est conforme au cash flow hypothesis de Lynch-Koski et Pontiff. Mais nous constatons également que le rapport entre l'utilisation des produits dérivés et les rendements passés devient négatif à la fin de l année, ce qui est conforme à la managerial incentive hypothesis de Brown, Harlow & Starks et de Chevalier & Ellison. En conclusion, les résultats obtenus à partir des données de la crise financière d'août 1998 montrent que les effets de l utilisation des dérivés sont les plus prononcés pendant les périodes de mouvement extrême bien que l utilisation observée des dérivés ne montrent aucune capacité de synchronisation avec le marché ex ante de la part des gestionnaires de fonds.

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Bibliographic Info

Paper provided by CIRANO in its series CIRANO Working Papers with number 2001s-62.

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Date of creation: 01 Nov 2001
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Handle: RePEc:cir:cirwor:2001s-62

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Related research

Keywords: Mutual funds; Derivatives; Hedging; Foreign Exchange Forwards and Futures; Fonds communs de placements; Produits dérivés; Couverture;

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References

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  1. Geczy, Christopher & Minton, Bernadette A & Schrand, Catherine, 1997. " Why Firms Use Currency Derivatives," Journal of Finance, American Finance Association, vol. 52(4), pages 1323-54, September.
  2. Chevalier, J. & Ellison, G., 1996. "Risk Taking by Mutual Funds as a Response to Incentives," Working papers 96-3, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, vol. 54(4), pages 513-33, October.
  4. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1978. "The Returns and Risk of Alternative Call Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 51(2), pages 183-242, April.
  5. Rene M. Stulz, 1994. "International Portfolio Choice and Asset Pricing: An Integrative Survey," NBER Working Papers 4645, National Bureau of Economic Research, Inc.
  6. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
  7. Jennifer Koski & Jeffrey Pontiff, 1996. "How Are Derivatives Used? Evidence from the Mutual Fund Industry," Center for Financial Institutions Working Papers 96-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
  8. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
  9. Brown, Keith C & Harlow, W V & Starks, Laura T, 1996. " Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry," Journal of Finance, American Finance Association, vol. 51(1), pages 85-110, March.
  10. Berkowitz, Michael K. & Kotowitz, Yehuda, 2000. "Investor risk evaluation in the determination of management incentives in the mutual fund industry," Journal of Financial Markets, Elsevier, vol. 3(4), pages 365-387, November.
  11. Figlewski, Stephen, 1984. " Hedging Performance and Basis Risk in Stock Index Futures," Journal of Finance, American Finance Association, vol. 39(3), pages 657-69, July.
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