Unmasking Mutual Fund Derivative Use

Abstract

Utilizing new SEC data enabling us to compute performance of mutual funds' derivative positions, we study how funds use derivatives and how derivatives contribution to performance. In contrast to prior research concluding derivatives are used for hedging, we find most active equity funds use derivatives to amplify market exposure by buying index derivatives, underperform, yet receive more flows. Hedging funds, the minority, in contrast utilize single stock derivatives. Despite small portfolio weights, derivatives significantly impact funds' leverage and contribute largely to returns and cross-sectional differences in returns. Swaps, ignored by prior studies, are especially important in explaining cross-sectional differences in derivative contributions. In response to the COVID-19 pandemic outbreak, funds trade more heavily on short derivative positions, a pattern driven by managers for which the risk of recession is likely more salient. Amplifying funds suffer a double whammy. While they shift strategies, they are slow to react and experience similarly large losses to nonusers in the outbreak. By the time they shift, the market has already started to rebound, and they lose on their short positions.

Keywords: COVID-19, Derivatives, Mutual Funds

JEL Classification: G01, G11, G12, G14, G23