Working Paper: CEPR ID: DP17755
Authors: Pingle Wang; Ron Kaniel
Abstract: Using new SEC data, we study how funds use derivatives and how derivatives contribute to performance. Despite small portfolio weights, derivatives significantly impact funds’ leverage and contributelargely to returns. Contrary to prior research concluding derivatives are used for hedging, we findmost derivative users buy index derivatives to amplify market exposure. Surprisingly, they underperform nonusers yet receive more flows. Using COVID-19 pandemic as a shock to evaluate explanations,we find they suffered a double whammy: failed to outperform nonusers by suffering losses from longderivative positions during the crash and from newly opened short positions when markets unexpectedly rebounded.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Derivative usage (C69) | Amplification of market exposure (G19) |
| Amplification of market exposure (G19) | Underperformance compared to non-users (D29) |
| Market downturns (E32) | Losses for amplifying funds (G32) |
| Long derivative positions during market crash (G13) | Losses for amplifying funds (G32) |
| Poor capitalization on short positions during market rebound (G19) | Losses for amplifying funds (G32) |
| Derivative-induced returns (DIR) (G19) | Negative correlation with market performance during crisis (G01) |
| Flows into amplifying funds (E50) | Driven by risk-taking channel (G19) |