The Securities Exchange Commission is currently reviewing the use of derivatives by mutual funds, and possibly considering imposing greater restrictions on their use. A recent Wall Street Journal blog noted this development and quoted from several mutual funds' comment letters to the Commission, including AQR Capital Management's:
Without the use of derivatives, it would be impossible for AQR mutual funds to achieve their objectives. Suffice it to say. we use derivatives in a variety of ways, including for hedging. But our primary use is to gain exposure to entire classes of instruments, rather than to individual securities.
An important issue is thus the extent to which mutual funds' use of derivatives may help to decrease risk or increase returns for investors, either by allowing them to diversify by accessing a wider class of assets or through ouright hedging. Looking at how hedge funds use derivatives may provide an some indication.
Regarding hedge funds' use of derivatives, a 2010 paper by Yong Chen found that derivatives make hedge fund less risky:
After controlling for fund strategies and characteristics, derivatives users on average exhibit lower fund risks, such as market risk, downside risk, and event risk; such risk reduction is especially pronounced for directional-style funds. Further, derivatives users engage less in risk shifting and are less likely to liquidate in a poor market state.
Similarly, a 2010 paper by Aragon and Martin found that hedge funds successfully use derivatives in the form of options to lower the volatility of and generally increase investment returns (page 3):
We find that option usage is associated with significantly lower after-fee return volatility and higher Sharpe ratio. Moreover, hedge funds deliver higher benchmark-adjusted portfolio returns and lower market risk both before and after greater reported option usage....our findings here suggest that hedge funds use option holdings to profit from volatility timing information and selectivity skill, and these rents are largely passed through to investors in the form of after-fee returns.
While two papers on how hedge funds use certain derivatives should not settle any issues, these and similar studies regarding how derivatives actually impact investment fund returns should be considered by regulators. In terms of investor protection, it seems that it is precisely because hedge funds are legally permitted to make a greater use of derivatives, short sales, leverage, and performance-based compensation than mutual funds that hedge funds are safer for investors in downmarkets.