Taking risks for high returns: Derivative-based instruments are being targeted at private investors

A TYPICAL offer designed to lure private investors into derivative instruments appeared in the national press this week: 'Double your money with warrants. More and more investors are now discovering the secrets of UK equity warrants . . . they concentrate on capital gain - often with spectacular results.'

Despite recent warnings from the regulatory authorities about the mis-selling of investments based on derivatives such as swaps, options (warrants are essentially long-term options) and futures, many more are about to be launched on private and institutional investors.

Small investors have been drawn to derivatives-linked products because they offer a much higher income than traditional deposits at current low interest rates.

High income funds of this type write call options on shares in their portfolio - that is, sell the right to buy the shares at a pre-determined price on a given date - and use the premium income they receive from this to pay savers more.

They also buy put options - the right to sell shares at a particular price - to guard against bigger falls in the price of their share portfolio. In other words, they use derivatives to reduce risk, but provide higher income at the expense of capital or capital gains.

One example is the successful Hypo Foreign & Colonial High Income Plan. It has taken in pounds 400m since its launch in April and is still attracting pounds 1m a day despite controversy.

A wide variety of products based on derivatives is available to retail investors. Major investment banks involved in the derivatives market report a number of deals with building societies and retail fund managers to launch new ones.

The regulatory authorities recently issued new guidance notes on the selling of some derivatives-linked products. Yet small investors are also dabbling directly in far riskier derivatives. According to Charles De Roeper of futures and options broker Berkeley Futures: 'A lot of private investors are interested at the moment because of the headlines about easy money in the City.'

Even the cautious pension and insurance funds are jumping on the bandwagon. For instance, two major fund managers, Mercury Asset Management and Gartmore, have approached their pension fund clients in recent months for permission to invest in derivatives. Some big funds are already sophisticated users of derivatives, but many others have not traded in them so far.

From next spring insurance companies' use of derivatives will be boosted by new regulations currently being drawn up by the Department of Trade and Industry. So far the insurers' interest has been limited by the fact that under existing regulations, derivatives have no value ascribed to them. One insurance industry expert says: 'Most of the companies will become interested in derivatives. A number have not yet appreciated how useful they are, but they soon will.'

Investment banks are expecting a bonanza year in 1994. The pace of growth of markets in derivatives is accelerating as more investors, institutional and private, turn to them to boost investment performance.

According to Tony Best of

J P Morgan: 'There is a massive increase in the use of derivatives. We have only seen the tip of the iceberg.' J P Morgan set up a derivatives marketing group last year to cope with the growing demand. T J Lim, head of non-dollar derivatives at Merrill Lynch, says: 'The growth in the market has been phenomenal and this will continue. The interest is becoming very widespread.'

Market participants report keen interest in all kinds of instruments, including highly speculative ones such as commodity futures. The catalyst has been falling interest rates in the United States and Europe, leading investors to look for new ways of enhancing returns.

However, many investors take the plunge without fully understanding the risks. Much of the derivatives market is unregulated. The financial regulators have rules on the selling of derivatives and linked products, but are concerned about 'inadequate' marketing literature.

In responsible hands some derivatives can be used to reduce risk, but others are extremely high-risk, high-return investments. As T J Lim puts it: 'The suitability of the instruments depends on the investor's understanding.'

Investment banks are keen to stress that the risks are exaggerated. One banker says: 'A market does not grow to USdollars 6 trillion in size if it is a stupid idea.'

But assurances like this from established players have not convinced banking supervisors. In a recent speech the Bank of England's head of supervision, Brian Quinn, pinpointed a serious problem: 'Expertise in derivatives trading is limited. If the demand for this new source of profit should expand faster than the supply of people capable of doing the business there can only be trouble ahead. Derivatives trading is for grown-ups.'

Whatever the regulators say, however, the business is so profitable that it is sure to attract unqualified juveniles, eager to sell derivatives to naive investors. There is plenty of scope for disaster.

(Photograph omitted)