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Derivatives, No Longer 'WMD,' Gaining Respect


They've been derided by Warren Buffett and feared by regulators, but some advisers are convincing clients that derivatives are helpful.

Back in 2002, when AIG was still in that ultra-exclusive Triple-A-rated club and its financial strength seemed all but unbreakable, the billionaire signaled an ominous warning in Berkshire Hathaway's annual report: "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Buffett didn't name names eight years ago. He didn't look into his crystal ball and see the near-collapse of AIG in 2008, caused by its $2 billion-dollar derivatives book. Instead, he simply cautioned that large amounts of credit risk had become concentrated in the hands of a small number of derivative dealers who trade back and forth with one another. He predicted that the instruments would continue to multiply in number and variety "until some event makes their toxicity clear," aptly noting that neither central banks nor governments had devised an effective way to control and monitor their far-reaching risks.

Fast-forward about seven years to this past December, when Ed Keon, managing director and portfolio manager for Prudential Financial's Quantitative Management Associates (QMA), released Turbulent Teens Ahead?, a whitepaper that evaluates market prospects in the new decade. "As much as derivative products have been shunned as 'weapons of mass destruction,' my guess is that certain derivatives may become more important as investors discover their value as a way of potentially limiting or focusing risk exposure."

As Keon was writing the paper he was thinking about Against the Gods, the book about risk written by the late economist Peter Bernstein. Essentially Keon had in mind the basics of what derivatives were conceived to be: ways to either take risks or hedge risks.

And yet, Keon acknowledge that some of QMA's clients are reluctant to invest in products that include derivatives because of their bad reputation-but that can be overcome by education.

Yet, Keon also recognized the dangers of counterparty risk and transparency, and said that if this mysticism could be stripped away, derivatives could even become user-friendly. Explaining "derivatives strategies is a difficult sale," Keon said; focusing on their potential effects is a better way to go.

The notional amount of outstanding over-the-counter global derivatives contracts was about $604 trillion at the end of June, according to the Switzerland-based Bank of International Settlements. This represents a drop from $684 trillion at the end of June 2008, but an increase from $516 trillion at the same point in 2007.

Options and managed futures are two derivative styles that appear to be gaining traction. Steve Quirk, managing director of trading for thinkorswim, a TD Ameritrade-owned online brokerage that specializes in options, expects the derivatives market to remain strong, and noted that option trades are up 125% over the past two years, largely driven by the dour market conditions.

Investors "figured out that they can't be the buy-and-hold, one-trick pony anymore," Quirk said.

One goal of trading options is to supplement income generated by a portfolio. Options are beneficial to investors if they anticipate a certain directional movement in the price of a stock, because it allows them to buy or sell that stock at a predetermined price for a specific duration.

One important development in the options market, Quirk said, is that as derivatives have become more desirable as an instrument to trade, they've also become more liquid. As they become more liquid, the pricing around option trading becomes better. Right now there are about 68 optionable stocks that trade in penny increments.

"That's important because when you go to get in and out of trades you're giving up a dollar," Quirk said. "Twenty years ago you were giving up $100. Five years ago you were giving up $20. So it's made it a very efficient market."

Adam Rochlin, head of MF Global's Alternative Investment Strategies Group, says that at a strategic level, derivatives are neither a bad nor a good thing. Managed futures, for instance, have held up well to other products over the past several years, he said. In 2008, when equities had one of their worst years in several decades, managed futures were up 14% as measured by Barclay's CTA Index.

There is a definite learning curve for investing in derivatives, one that might be steeper than for most other investments. Lou Stanasolovich, CEO and president of Legend Financial Advisors in Pittsburgh, says he and his staff studied managed futures for two years before using them. Still, they won't invest in "true derivatives" like tranches of Ginnie Mae, relying instead on other managers such as PIMCO.

"We often see advisers and individuals owning things that are way beyond their capabilities or knowledge base," Stanasolovich said.