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Warning Flag for Investors : Careful look is needed before buying into mutual funds holding 'derivatives'

October 09, 1994

If ever a mutual fund investor needed to understand the arcane financial instruments known as derivatives, this is the time. Losses in derivatives last month forced the first outright failure of a money market fund. Never before had a penny been lost, so the funds--which are uninsured--had acquired a reputation for absolute safety. Investors beware.

Does your mutual fund have some of its assets in derivatives, the financial contracts that derive their value from another asset, such as stocks, bonds or commodities? If so, do you know how much, and what the risk might be?

Finding the answers may not be easy, because public disclosures about derivatives are far too limited. This lack of information poses a special risk for small investors, many of whom have put their money in higher-yielding mutual funds instead of bank accounts in recent years. The more information available the better.

To protect investors, Securities and Exchange Commission Chairman Arthur Levitt Jr. proposes not only greater disclosure but also reducing the maximum allowable percentage of a mutual fund's assets that can be held in derivatives. Levitt's proposal makes sense.

When used intelligently and with care, derivatives can help to hedge risks and can provide immense benefits by creating a pool of worldwide financial resources. But mutual funds certainly have had their problems with derivatives lately. Last month's collapse involved Community Bankers U.S. Government Money Market Fund in Denver. Fortunately, damage was small and contained. The 94 shareholders, all institutional clients, will get back 94 cents on the dollar.

Community Bankers had $35.5 million of its $82.2 million in assets in derivatives--more than 40%, far above the 15% ceiling established by the SEC. Primarily, those derivatives involved secured notes created from a variety of U.S. government agency securities. When interest rates were falling, the derivative instruments helped boost fund yields. But when interest rates started rising, trouble too quickly arose. The fund decided to liquidate rather than cover mounting losses.

Other brokerages and banks, including Bank of America, recently have had to put up millions to cover derivative losses in their mutual funds to protect investors.

The SEC's proposed changes, in addition to calling for greater disclosure, would reduced to 10% from the current 15% the maximum that any fund could invest in "illiquid" securities, a category that includes most derivatives.

The big question is how to measure risk. The SEC will solicit write-in comments on its proposals in early 1995. Meanwhile, mutual fund investors should ask plenty of questions about derivatives and make sure they know where their money is going.

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