Beware of Mutual Funds Use of Derivatives

In order to hedge their returns (the good news), mutual funds may be using complex financial instruments known as derivatives (the bad news). Regulators and fund watchdogs are raising concerns because these are being placed in what historically have been plain-vanilla, diversified stock and bond funds.

Three types of derivatives are popular among mutual funds. First, covered-call options, to generate a steady stream of income. Second, credit-default swaps, to increase or decrease credit risk in bond funds. Third, index tracking, often to amplify the performance of an index, either upward or downward.

Some funds using derivatives are: Eaton Vance, Federated Investor, Rydex Investments, Fidelity Investments and Amvescap's AIM Investments.

Warren Buffet calls derivatives "financial weapons of mass destruction." Be careful!

Source: Wall Street Journal, April 4, 2007