DERIVATIVES: FRIEND OR FOE?

DERIVATIVES: FRIEND OR FOE TRANSCRIPT

First published on 9 November 2010 as part of our Smart Investment Month in association with the Telegraph.

NIKI CHESWORTH: Mention the word ‘derivatives’ and most of us think of rogue traders and spiraling losses from speculative investments. And yet many of us probably own derivatives, because they’re used by unit trusts and pension fund managers to help manage our money.

Here to demystify the whole derivatives issue and to tell us whether they’re our friend or our foe, we have Ashley Goldblatt, who is Fixed Income Product Director from Legal & General.

ASHLEY GOLDBLATT: Hi, Niki.

NIKI CHESWORTH: So, Ashley, first of all can you tell us what is a derivative? I think part of the problem is we fear what we don’t know. And if we understood derivatives better, maybe we’d be less fearful.

ASHLEY GOLDBLATT: Probably the starting point is not derivatives but actually talking about physical assets. Most of us are very familiar with bonds, equities, commodities, property. And although these asset classes are familiar, what we tend not to think about is that they come with certain limitations in terms of what they offer or how they’re transacted. The reason derivatives were invented was to try and ameliorate or get over some of these limitations.

NIKI CHESWORTH: So can you put that into context with a physical asset? Because that’s often easier to understand, isn’t it.

ASHLEY GOLDBLATT: Well, let’s talk about one which has been in the news a lot recently: gold. You know, if somebody wants exposure to the gold market, they could ring up a commodities broker and buy some gold. But if they do that, then they don’t get an income from gold because it’s a commodity and, worse, they actually lose income, because almost certainly there are going to be storage or insurance costs associated with holding the gold.

The purpose of having gold commodity derivatives is to try to get exposure to the economic effect of gold – hopefully get the price increases – but without having the associated costs.

NIKI CHESWORTH: So instead of owning a physical asset or a share, you own a derivative of it. And the value of that derivative derives from the value of the asset that it’s linked to?

ASHLEY GOLDBLATT: That’s it! Sometimes the correspondence is quite precise, such as the linkage between the gold derivative and gold itself. Sometimes it can be quite complex. But whatever it is, somehow or other there is a linkage between the two.

NIKI CHESWORTH: So why do we have this perception that they’re so risky?

ASHLEY GOLDBLATT: Well, I think there are two reasons for that. The first is what you alluded to earlier, which is they tend not to be well understood outside of the city. But the second thing is there have been some high-profile cases where significant losses have been made, and those losses have been linked to derivatives.

But what that disguises is the fact that each day there are literally hundreds of thousands of derivative-related strategies put in place each and every single day where everything that goes on is exactly as is expected.

NIKI CHESWORTH: I understand that under European fund rules known as UCITS3, fund managers who look after our everyday money in unit trusts are allowed to use derivatives. So presumably they wouldn’t allow that if they were these high-risk investments?

ASHLEY GOLDBLATT: Well, I think that’s a natural conclusion you can draw. There are only two ways in which we would be expected to use derivatives. The first is to try and create positions efficiently, and the second is to manage those positions once they’re in portfolios. As long as we do that and follow some very sensible rules laid down by the regulators, that’s perfectly permissible under European law. And what we should get to are results that you should be able to achieve exactly through using physical instruments but actually with cost savings or, rather, efficiencies which are only available through the derivatives market.

NIKI CHESWORTH: So you could, for example, buy an index using a derivative and you’d just get the same return?

ASHLEY GOLDBLATT: Absolutely. And in fact that’s a very, very good example. I mean, let’s suppose you wanted to have an exposure to the UK stock market. If you wanted to replicate the features of the 100 Share Index, can you imagine how much time and money you’d have to spend buying the right proportion of every share in that index – it would take you forever! But through derivatives we can buy that exposure in one go at very, very small cost.

NIKI CHESWORTH: And then what about hedging? I’ve heard that derivatives can be used to ‘hedge your bets’, so to speak. So if you’ve got a big exposure to a particular currency, you can hedge to make sure you don’t suffer, or the portfolio doesn’t suffer, if that currency falls in value.

ASHLEY GOLDBLATT: Well, this is one of the beauties of using derivatives. In the physical market you can only be what’s called ‘long’ of the instrument – you can only either hold it or not hold it. But in the derivatives market you can actually have negative positions.
Now, that probably sounds a bit strange and maybe even a bit scary, but actually if you’re holding an exposure to a physical asset, and through using a derivative you can negate that exposure in part or in whole very, very quickly and very cheaply, you can actually get far better risk management than only restricting yourself to the physical world.

NIKI CHESWORTH: So you talk about ‘risk management’. When we talk about the other hedge funds, they use derivatives, don’t they, to magnify returns and sometimes magnify losses. So there’s a different use of derivatives there?

ASHLEY GOLDBLATT: No, it always comes back to the same two things: of creating positions and managing positions. In a sense, hedge funds have got the same publicity image as derivatives themselves. But most hedge funds are actually run so as not to indulge in the sort of behaviour that you talked about, but actually to trot out very risk-controlled accruals of returns rather than shoot-the-lights-out-type performance.

NIKI CHESWORTH: But, of course, hedge funds are for the sort of sophisticated, wealthy, knowledgeable investor who’s prepared to take that level of risk.

ASHLEY GOLDBLATT: Absolutely right.

NIKI CHESWORTH: So it’s a question of understanding what we’re investing in. And we often fear what we don’t understand. And if investors had a better idea of the use of derivatives, maybe they’d be less concerned!