Academic journal article Financial Services Review

An Investigation of the Impact of Derivative Use on the Risk and Performance of UK Unit Trusts

Academic journal article Financial Services Review

An Investigation of the Impact of Derivative Use on the Risk and Performance of UK Unit Trusts

Article excerpt

Abstract

A popular investment choice for UK investors is unit trusts. This paper examines the impact of derivative use on the risk, performance, and risk management of UK unit trusts between January 1995 and December 1997, extending an earlier US study. Despite the well-documented increased use of derivatives by corporate investors, approximately three-quarters of our UK sample did not use derivatives, consistent with US evidence. The main findings of the paper show that the cross-sectional variability of a number of risk measures tends to be larger for trusts that use derivatives compared with those who do not use derivatives. Derivative use tends to have little influence on performance inferences for the overall sample of trusts but does for some investment sectors of our trust sample. Finally, and in contrast to evidence in the US, trusts that use derivatives tend to have less severe changes in risk due to past performance within a calendar year. The findings have important implications for the existing regulations in the UK on derivative use by unit trusts that prohibit the use of derivatives for speculative purposes and for the large number of individual investors who invest in these trusts.

JEL classification: G23; G18

Keywords: Derivatives; Unit trusts; Performance; Risk

1. Introduction

Derivatives have expanded the portfolio of investment choices, and their use is growing. An important consideration for individual investment is whether or not to use derivatives. If investors choose to use derivatives they can use them to hedge their position and/or for speculative purposes. For the many individuals in the UK who use unit trusts as a form of investment, these decisions belong to the fund manager. It is therefore very important to consider the impact of this derivative use on the performance and risk of the unit trust. Because the managers of these trusts invest on behalf of the individual investors their use of derivatives is a matter of public interest. In the UK derivative use in these funds is governed by regulators with the intention of ensuring that the managers of these trusts use derivatives for the purpose of "efficient portfolio management," defined as controlling risk, generating additional income, or reducing costs but not for speculation.

There has been a huge growth in derivative markets and derivative use by companies and financial institutions (Grant & Marshall, 1997; Bodnar et al., 1998; and Whidbee & Wohar, 1999). Theoretically, derivative use provides a number of benefits, and it has been suggested that users will improve their performance and lower risk relative to non-derivative users (Allayannis & Weston, 2001 and Guay, 1999). However, with the near collapse of LongTerm Capital Management, the losses incurred by a number of financial institutions, such as Barings, and the widely publicized losses by corporate investors associated with derivative transactions and the subsequent lawsuits (Gibson Greetings and Proctor and Gamble, see McCarthy, 2000), a perception does exist that derivative use is highly risky and regarded as a speculative tool (Koski & Pontiff, 1999).

Unlike this speculative image, finance theory predicts that profit maximizing corporate investors hedge risk exposures in an effort to reduce the costs associated with agency problems between bondholders and shareholders, financial distress, and taxes (Froot et al., 1993, and Mian, 1996). The empirical results on these theories have been mixed, and a number of recent papers are refining the data and samples. Graham and Rogers (Is corporate hedging consistent with value maximization? An empirical analysis, unpublished working paper, Northeaston University, 2000) provide a summary. Nonetheless, there is little prior research about the extent of derivative use in more traditional investment institutions, such as pension funds, mutual funds, and unit trusts. This is an extremely important omission as these funds invest on behalf of a large number of individual investors. …

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