Large losses in a local unit trust fund in December last year have exposed the danger of using derivatives to protect portfolios against falling share prices. The fund involved was using a high-risk strategy, but it was available only to sophisticated individual and institutional investors.
While most unit trust funds in which consumers typically invest use derivatives (see “Definitions”, below) to give some protection to the portfolio when markets are likely to fall, and investors and their advisers should be sure they understand how their funds use derivatives, the strategy of the fund that now has the dubious honour of being the worst-performing unit trust fund in any category over both the one- and three-year periods to the end of the December, is not a common one.
The Third Circle MET Target Return Fund, a multi-asset flexible fund, used derivatives to deliver performance that was “uncorrelated” with the returns other multi-asset funds would produce. According to the fund’s manager, Ian Lane, the strategy aimed to deliver most of the positive returns of the market while offering protection against losses.
But in December last year, after former Finance Minister Nhlanhla Nene was removed from his post and share prices fell sharply before recovering, the fund’s strategy failed and it returned minus 58.61 percent over the quarter to the end of December and minus 52.95 percent over the year to the end of December. Its three-year annualised return to the end of December was minus 21.69 percent.
Lane describes the market conditions at the time as “extreme” and says the events following Nene’s dismissal were a “black swan” that Third Circle believed had very little chance of becoming a reality. Third Circle may have “underestimated the likelihood of such an event” and is reviewing its strategy, Lane says.
Both the unit trust regulator – the Financial Services Board (FSB) – and Metropolitan Collective Investments (MetCI), on whose collective investment scheme licence the fund was registered, are investigating whether the losses incurred were the result of negligence or non-compliance with regulation.
The Third Circle MET Target Return Fund is what is known as a white-label fund: it does not have its own collective investment scheme licence and the Collective Investment Schemes Control Act (Cisca) makes MetCI, part of the MMI group, responsible for the fund’s compliance with the Act and its own mandate.
MetCI this week completed its investigation into the positions held by the fund and whether there were any failures in complying with Cisca, but Mickey Gambale, the chief executive of MetCI, says it found the fund was compliant with both the Act and its own mandate. This was confirmed by the fund’s trustees, Standard Bank of South Africa, Gambale says.
He says the fund’s losses were a result of the market volatility at the time.
Lane’s explanation of how the fund incurred the large losses, however, reveals that the fund held exposure to shares on the JSE such as Absa, FirstRand, MTN, Nedbank, Remgro, Sanlam and Woolworths not by owning the shares themselves, but through options to buy these shares.
The fund also held protection from equity market losses through an option structure on the FTSE/JSE Top40 Index.
The sharp losses on the JSE following Nene’s dismissal in December took the fund into a position where it was in breach of Cisca’s investment limits, and Lane and his colleagues were forced to unwind the share options at the very bottom of the market’s sharp decline. This locked in losses for investors.
The fund’s option on the Top40 failed to provide the protection it was intended to provide because the rand weakened substantially and the rand-hedge shares (which earn much of their profits offshore) in the Top40 prevented the index from declining as much as the shares on which the fund held options, Lane says.
Many South African unit trust funds have exposure to derivatives, but unit trust funds are regulated by Cisca, which requires that their derivatives exposure is limited to the purpose of protecting the portfolio from losses.
This exposure to derivatives must be what is known as “covered”. This means that the fund must own the shares and be able to deliver them if it uses derivatives to short the shares when it believes the share price will fall, or it must have the cash to buy shares when it takes an option to buy.
This limits the losses a fund can incur using these instruments.
Adri Messerschmidt, a senior policy adviser at the Association for Savings & Investment SA, says the use of derivatives by collective investment schemes is controlled by a board notice under Cisca that sets out how the derivative positions need to be “covered”. This states that the effective exposures of listed derivatives plus the market value of physical underlying assets in the portfolio – that is the shares and bonds or other instruments – must be less than the market value of the portfolio.
The board notice also says that if a fund owns a derivative on an index, it must maintain exposure that is highly correlated or similar to the index.
In the days after Nene’s dismissal, however, the Top40 index’s performance was not correlated with that of the shares held by the Third Circle fund.
Lane says the fund’s investment strategy was a complex one, but it complied with Cisca and was marketed only to investors who could appreciate the risks involved.
Jurgen Boyd, the deputy registrar of collective investment schemes at the FSB, says the FSB is not able to comment on the losses incurred by the Third Circle fund until its investigation is complete. He says that, as with other types of investments, investors in collective investment schemes take on investment risk, and the registrar of collective investment schemes generally does not investigate the circumstances behind losses incurred by investors. However, where it appears that a manager may have been negligent or failed to operate a fund or portfolio in a responsible manner, resulting in prejudice to investors, the registrar will investigate and take regulatory action if necessary.
Since May last year, unit trust companies have been obliged by a board notice issued in terms of Cisca to reveal certain information about their funds in a minimum disclosure document.
The minimum disclosure document for the Third Circle Met Target Return fund issued in November last year failed to explicitly disclose the extent of its derivative exposure and stated that the fund had most (between about 96 and 98 percent) of its investments in cash and money market instruments, which was technically correct but did not reflect the exposure investors experienced.
Boyd says the requirements for the minimum disclosure document do not explicitly require disclosure of investments in derivatives. However, he says, a manager is required to set out in the document sufficient information to enable an investor to fully understand the nature and the risks of the portfolio.
The FSB’s investigation will also consider whether the manager’s failure to disclose the fact that derivatives were used extensively in this fund breached its disclosure requirements and the principles of Treating Customers Fairly that the FSB has adopted.
The fund’s minimum disclosure document was prepared by MetCI and approved by Third Circle.
Messerschmidt says one of the requirements for funds that make use of derivatives is that the deed and supplemental deed of the collective investment scheme must provide for it.
DEFINITIONS
* Derivative. A security with a price that is dependent on or derived from an underlying asset, such as a share or bond. It is a contract between two or more parties, and its value is determined by fluctuations in the underlying asset.
* Option. A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a share or bond, is a security. It is also a binding contract with strictly defined terms and properties. – Investopedia