Do Derivatives Enhance or Deter Mutual Fund Risk-Return Profiles? Evidence from Italy

Abstract

We analyze the use of derivatives in Italian equity mutual funds from December 2002 to May 2007. We find that the average asset allocation in derivatives increased by around 50% during this time frame, roughly coinciding with the harmonization of Italian regulation of mutual funds to European standards. During the same period, users of derivatives significantly increased their risk-adjusted performance, increased their market risk exposures, reduced idiosyncratic and total risk, reduced skewness, and increased kurtosis. In contrast, non-users of derivatives increased their overall performance without either increasing their market exposures or changing the skewness of their returns. In spite of the increased exposure to derivatives, overall risk reduction was equal for both users and non-users of derivatives. These findings do not support the public perception about the use of derivatives as a means to increase risk through speculation.

Keywords: Mutual funds, derivatives

JEL Classification: G11, G21, G32