Article September 28, 2021

The ease of implementing derivative strategies


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Implementing a robust risk management strategy using derivatives is not difficult. In fact, the use of derivatives to prudently manage risk and improve portfolio efficiency is increasingly accepted by institutional investors as a legitimate and powerful concept. However, despite the conceptual buy-in of many institutions, implementation is not as common.  Some institutional investors have chosen to not adopt derivatives as they perceive a difficultly in implementing and monitoring a derivatives portfolio. This perception is often driven by institutional advisors who have never overseen an implementation and therefore believe it to be “too hard”. This note provides more information on the implementation process, in order to clear up some of the misconceptions that persist in the industry.

Implementing a derivatives strategy is far less difficult, far less complex, far more transparent and far less costly than implementing a new allocation to illiquid investments such as private equity, real estate or hedge funds. Institutions should question whether their objectives are more likely to be met by adding (hidden) leverage via these alternative investments or through the prudent use of leverage at a portfolio level using derivatives.

So, what does it take to actually implement a derivatives-based strategy at a portfolio level?

STEP1: Appoint an Asset Manager

As with any other asset class, an institution will need to select an asset manager who can transact and manage derivatives on behalf of the fund.  The institution will enter into an investment management agreement which will delegate to the asset manager the ability to setup derivatives related documentation and transact derivatives on behalf of the institution. This will also provide the asset manager the authority to manage the collateral accounts which help to manage the counterparty risk (see Step 3).

STEP2: Enable Derivatives with Trustee/Custodian

All of the largest custodians, and many of those that are more focused on the mid-market, can handle derivatives.  Thus, for institutions with these custodians, derivatives activity can be enabled in weeks.

A potential issue that can delay implementation is that some smaller custodian platforms in the US do not support booking derivative positions.  Such smaller custodians have software or processes that have not been updated in many years and who are unwilling (or unable) to change them. For these situations the solution is to move to a custodian with a modern platform. While changing custodians is not a fun process, it is also not particularly painful nor time consuming for the institution and the work can be delegated to, for example, the team that will implement the derivatives strategy. In many cases the client will not pay more to move to a modern custodian.

Once a custodian is finalized, they will need to enable derivatives by setting up two additional accounts where the derivatives and associated cash and US Treasury collateral will be held.

STEP3: Governance and Investment Policy

Many institutions have investment policies that may severely limit or even prohibit the use of derivatives at a portfolio level. These policies are living documents and changing them is generally a straightforward process. This process may require education and dialogue, but no new investment should be made using derivatives or any other asset class without the relevant people charged with governing the institutional funds being fully on-board. Educating fiduciaries, committee members, and other key stakeholders on how to prudently use derivatives is a key part of the process and the education can be done by the selected derivatives asset manager as part of their agreement.

When approved, the derivatives manager can execute the strategy as per the terms of the agreement.  The manager will monitor, potentially rebalance the strategy, if mandated, and manage any collateral associated with the strategy.

STEP4: Reporting

The value and returns associated with a derivative position will be reported by the appointed asset manager.  Most custodians will also report the value of the derivative asset, alongside all other assets.

Incorporating derivatives returns and oversight into an institutional wide report is likely to require some changes to existing reports if derivatives incorporate a degree of “leverage” at the portfolio level (i.e., the exposures to various assets sum to more than 100%). In our experience, it is possible in most systems to find a work-around within the system to this issue, but in some cases the system will need to be modified. While this could be something that causes implementation pain, it could also be an opportunity to evaluate whether the reporting system or provider is up to the task of accurately reflecting modern portfolios (see Step 2).

Most derivatives used by institutions are ‘Type 2’ assets from a financial reporting perspective. This means that they are not publicly traded with a single observable market price, however they can be valued easily using readily available market data and standard methods. Auditors are typically comfortable with the value of such derivatives, as reported on custodial statements.


Too often, we have seen the “tail wag the dog” where institutions don’t do something that will add a lot of value simply because it doesn’t fit their current or historical framework, or their advisor is not willing to put in the work to do something different. In a world with exceptionally low expected returns on a forward-looking basis, every basis point counts. Allowing good investment ideas to be sidelined just because someone might have to do some work to make it happen is a poor excuse for inaction. There are better ways to invest portfolios and one of those ways, for many institutions, is to use derivatives to significantly increase the efficiency of the portfolio. Institutions that continue to avoid using these strategies simply because they seem “too hard” to implement will fall behind their peers who do.

SECURITY INDICES: This presentation includes data related to the performance of various securities indices.  The performance of securities indices is not subject to fees and expenses associated.  Investments cannot be made directly in the indices.   The information provided herein has been obtained from sources which River and Mercantile LLC believes to be reasonably reliable but cannot guarantee its accuracy or completeness.
CONFIDENTIAL:  For addressee use only, not to be disclosed to any other person without express consent from River and Mercantile LLC.  Past performance cannot be relied upon to predict future results.  River and Mercantile LLC is an investment advisor registered with the US Securities and Exchange Commission.

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