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Mutual Funds

July 1, 2009 – 10:35 am

Millions of investors have invested their money in various types of mutual funds to grow their assets. These funds can either be diversified stock funds, target specific funds, or bond funds. However, you may not know that your mutual fund could also be investing in risky derivatives to enhance performance, asking the question, “How safe is your mutual fund?”

Mutual fund managers will sometimes use various types of derivatives to boost returns of their mutual funds. However, the consequence if they are wrong means amplified losses. Bond mutual funds may invest in credit default swaps. These have become popular recently because they are easy to trade and many times cheaper. It makes it a simple way to increase or decrease a portfolio’s credit risk. The problem is that these are swaps and not securities; they do not trade on exchanges. This makes it extremely hard if not impossible for the SEC to know how much risk the mutual fund is taking.

Covered calls are also used by portfolio managers. A covered call is nothing new for investors. You sell (write) a call option on a stock you own. The option gives the buyer the right, but not the obligation, to buy your stock within a set time at a specified strike price. It can be used as a way to boost the fund’s income with the premiums made from writing calls. It can also offer a little downside protection. However, what happens if the stock takes off? The fund would give up all the stock’s profit above the strike price as the call holder exercises the option.

To see if your mutual funds invest in these types of derivatives, you will have to take a look at the prospectus. There it will tell you if the fund is allowed to use derivatives and if so it will tell you how much is held in derivative investment. If they are invested in these, make sure the percentage is not overwhelming.

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