Fund Manager’s Use of Put Options Was Speculation, Not Hedging
The SEC settled an enforcement action against a mutual fund manager alleged to have used options to such an extent that the strategy became speculative rather than hedging. The SEC says that the prospectus and SAI only allowed the use of options for hedging purposes. During 2009 and 2010, the adviser pursued an options strategy, buying put options on stock index futures and ETFs, which cost the fund dearly as the market rose. The SEC says that the adviser committed as much as 75% of fund assets to options in 2010. The SEC charges that the level of options trading “went well beyond hedging and amounted to speculation because the quantity of the put options purchases was incompatible with a hedging strategy.” The SEC claims that the notional amount of the options was 2.6 times the equity portfolio in 2009 and 8.5 times in 2010. Also, the cost of purchasing the options represented 16% of the cost of the equity portfolio in 2009 and 57% in 2010.
OUR TAKE: This case gives some guidance on how to draw the lines between hedging and speculation when using derivatives. The SEC implies that a firm is speculating and not hedging when the notional value exceeds the value of the securities being hedged (although the SEC did not indicate whether a less than a 1:1 ratio could be considered speculation).