USING DERIVATIVES TO ENHANCE PORTFOLIO MANAGEMENT
"Where derivative instruments are used for any other purpose permitted in terms of the Notice, no derivative instrument may expose the fund to the risk of losing more than its initial investment in that derivative instrument."
It is to be noted that this section is only applicable in the instance where derivatives are used for purposes other than hedging which means that it will only be of relevance in the instance where a derivative is used so as to enhance portfolio management. The fact that the derivative instrument must be responsible for exposing the fund to the risk of losing more than its initial investment provides the following problems, especially with regard to exchange traded options and futures. This discussion is further not to be divorced from the meaning of the term "leverage" which is undefined by the Notice in its current form.
FUTURES: where the fund is buying any particular asset forward, the initial investment will be the value of the forward contract which will be calculated by taking account of the price of the reference asset. The question would need to be posited as to whether the prohibition on obtaining leverage includes the use of margin by a Fund. Section 1.1 of the Notice prohibits a Fund from using a derivative instrument to obtain leverage. Should this be interpreted to mean that a Fund will be prohibited from using margin a Fund wishing to purchase certain assets forward will be obligated to settle the full contract price at conclusion of the agreement. A strong case can be made that where assets are purchased on margin the leverage arising there from will not be caused by the derivative instrument but the relationship between the broker and Fund. A Fund will thus be exposed to the possibility of losing more than its initial investment should the asset be purchased on margin and provided the price of the reference asset falls below a certain level. In this regard the use of margin will be responsible for causing the risk and not the derivative instrument.
In addition; where a fund settles the entire purchase price in respect of a futures contract, any losses that the Fund will be exposed to will not be caused by the derivative instrument but by market forces outside of the derivative instrument and in relation to the relevant reference asset. In deciding on whether to use a futures contract the following question would need to be asked: Is it the intention of the legislature to mean that a derivative instrument will be responsible for any losses suffered by a Fund by virtue of the nature and structure of the futures contract in allowing its value to fluctuate as a result of market forces in relation to the reference asset? If this question is to be answered in the affirmative a Fund may wish to refrain from using futures to enhance the portfolio management of a Fund inasmuch as fluctuations in the values of the reference assets could cause large price swings in that of the derivative instrument and thereby cause dramatic losses for a Fund. OPTIONS: in terms of an option a party will be responsible for the payment of an initial premium for the right to buy or sell the relevant reference asset at the contractually agreed strike price. The strike price will be enforceable regardless of any adverse market values. Such prices will however inform the decision of the option holder as to its decision in exercising the option. Should the option holder decide not to exercise the option, it will only lose the premium paid for the privileges granted thereby.
In such a situation, the option holder will not be exposed to the risk of losing more than its initial investment in the particular derivative instrument, being only the premium that is subject to loss where the option remains unexercised. At first glance, this seems to be what has been intended in terms of the wording of section 1.3.2. The position however changes when the concept of margin is introduced into the matrix.
Where options are purchased on margin the initial investment will consist of the margin payment which will provide the Fund with full exposure to the reference asset irrespective of the fact that the Fund would only have paid part of its entire purchase price. Provided the price of the reference asset does not fall below a certain level, the Fund will not be exposed to the risk of losing more than the amount initially invested. Should the Fund however decide to divest itself of the instrument purchased on margin during the life of its existence, or should the price of the asset fall below a certain level, the Fund will face the risk of losing more than the amount initially invested. As stated earlier, the cause of these risks lies in the use of margin and not the derivative instrument.
To reiterate, even if margin were to be disallowed any losses that a Fund stands to face would be caused by market forces in relation to the relevant reference asset and the derivative instrument would thus not be responsible for any risks so posed.
The current wording of the section would therefore necessitate the conclusion that a derivative instrument would never be responsible for posing the Fund with the risk of losing more than the amount initially invested; this could not have been the intention of the legislature and careful consideration should thus be paid to the structure and nature of derivatives and the various causes of price fluctuations in relation to them. Some solutions can be provided to the problems alluded to thus far.
With regard to margin; the legislature could not have intended to prohibit its use seeing as the optimal management of the Fund depends on the strategic implementation of practices such as margin. This ambiguity can be resolved by defining the concept of "leverage" as used in the Notice so as to exclude the prohibition on the use of margin.
As for fact that the derivative instrument must be responsible for posing the Fund with the risk of losing more than the amount initially invested; clarity is be required in order to ascertain whether price fluctuations of the reference assets over which the derivatives are issued are included within the ambit of section 1.3.2 of the Notice. In addition, attention should be paid to activities that may be performed in respect of derivative instruments. For instance, where a Fund holds certain positions with regard to options, the act of selling the instrument may expose the fund to losses in excess of the amounts initially invested. Problems such as this could be resolved by assigning definitions to acts such as the active trade in derivative instruments. This will bolster the approach and framework of the Notice in dealing with the risks faced by Funds when using derivative instruments and the practices involved.
Although the permissible limits for derivative instruments as prescribed by regulation 28 are relatively small, compliance with its provisions are of crucial importance. Asset managers and trustees of Funds are thus to proceed with caution in using derivative instruments for purposes other than hedging. This will be of particular importance where derivative exposures are obtained from entities that do not currently implement and utilise practices that are compliant with the Notice. Hedge funds are of particular importance in this regard. Where a Fund wishes to obtain its derivative exposure through a hedge fund, such a hedge fund will be required to comply with the provisions of the Notice.