As recommended in any investment proposal, investors should read the fund prospectus and other legal documents before making an investment decision. By doing so, investors are finding more often than not a sentence which states that the fund may use modern portfolio management techniques to achieve its investment goals. Even as these techniques and the instruments are mentioned in more detail in the prospectus, most (retail) investors struggle to understand the effects of these complex techniques for the portfolio and its results.
That said, here are some brief explanations of the most commonly used modern portfolio management techniques and their impact on the portfolio. Modern portfolio management techniques include the use of derivatives, securities lending, and option strategies as key tools for hedging, enhancing returns, and managing liquidity. Let’s explore these aspects in more detail.
A very common modern portfolio management technique is the use of derivatives for hedging and performance enhancement. The portfolio managers of mutual funds and ETFs use derivatives such as futures, options, and swaps to protect portfolios against adverse price movements. This is much more efficient than to sell positions in the portfolio if a portfolio manager wants to hedge a portfolio against a potential market downturn.
These derivatives can also be used for performance enhancement since derivatives can also amplify returns, such as by taking leveraged positions. This means that the portfolio manager is using options or futures to gain exposure to assets without fully purchasing them.
Beside these two purposes, derivatives can also be used to overcome liquidity issues in single securities or market segments. The so-called synthetic exposure allows portfolio managers to gain exposure to less liquid assets without directly buying them. In addition, portfolio managers can build an exposure to assets which are not eligible for direct investments, such as commodities under the UCITS regulation, by using swaps.
Another use case for derivatives is efficient cash management. While mutual funds face inflows and outflows every day, the portfolio manager needs to maintain a sufficient market exposure to meet investor goals. The use of derivatives enables fund managers to manage cash flows effectively, especially in times of redemptions or subscriptions, by maintaining market exposure while liquidating or deploying cash.
Another modern portfolio management technique is securities lending. The main purpose of securities lending is the generation of additional revenue. To achieve this, mutual funds and ETFs lend out their securities to other financial institutions (mainly for short selling purposes) in exchange for a fee. To secure the lend out securities, lending agreements typically require collateral to reduce counterparty risk.
A not so widely used modern portfolio management technique is call option writing. This is also called covered call strategy and means that the fund manager might write (sell) call options on stocks owned by the fund to generate premium income. This technique enhances returns of the fund, especially in sideways or mildly bullish markets. While covered call writing is considered as an income enhancing strategy which provides a steady income stream, it may limit the upside potential of the respective stock if the stock’s price rises significantly.
In addition, derivatives can be used for efficient dynamic rebalancing, as derivatives such as index futures can help to adjust exposures without selling or buying securities outright (which can incur transaction costs, tax impacts, and disrupt portfolio balance).
Risk management is another area where modern portfolio management techniques are used.
One good example of this is tail risk hedging, where the portfolio manager may use options or other derivatives to guard against extreme market events (e.g., a sharp decline in equity markets). Another example is interest rate hedging where the portfolio manager is using interest rate swaps or futures to hedge against fluctuations in interest rates.
These examples show that modern portfolio management techniques have benefits for portfolio managers and investors because they are very cost-efficient techniques which help achieve the investment objective of a mutual fund or ETF.
Nevertheless, the use of modern portfolio management techniques comes with some challenges, as the underlying derivatives and strategies can be quite complex. This means that the effective use of these techniques requires a deep expertise in derivatives and market dynamics. In addition, some of these techniques such as securities lending and derivatives involve risks if the counterparty fails to fulfill its obligations (counterparty risk). However, there are costs which needs to be taken into account, as writing options or using derivatives involves premiums or margin requirements that may erode returns in certain conditions.
While derivatives, securities lending, and call option writing are somewhat crucial tools in modern portfolio management, they must be carefully integrated to align with the fund’s objectives and regulatory framework. These techniques help fund managers strike a balance between risk, liquidity, and return, making them highly effective in the mutual fund and ETF space.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
