But these elements are only one stage in the process that this article seeks to address - the control of derivatives and compliance with those regulations.

The regulators have spent some considerable time consulting with the UK investment industry in order to ascertain what were sensible controls on the use of futures and options in investment funds. They sought guidance on the relative balance between risks being taken by potentially highly geared investments against the potential rewards from them. Several consultative papers and discussion documents were issued, in an attempt to find the right mix in terms of bought derivatives versus sold derivatives and versus the associated equities or bonds in the portfolio.

UK Authorised Unit Trusts (Mutual Funds)

Under the above regulations there are now three types of unit trusts, which can be categorised as follows:

Securities Fund

"A securities fund is a scheme dedicated to transferable securities and it will automatically fulfil the UCITS directives. Derivative transactions are governed by the guidelines known as "Efficient Portfolio Management" (EPM)."

This can be loosely described as the old-fashioned unit trust before the latest set of regulations, but with the additional benefit that it can now use derivatives through a set of guidelines known as "efficient portfolio management". In many cases the securities fund will have to change its trust deed before it can switch to using these new techniques. It will certainly have to change its deed if the previous wording had explicitly forbidden the use of derivatives, because the rules governing their use were less clear in previous regulatory environments. It is expected that the bulk of the fund will be invested in equities or bonds as before, but with occasional forays into derivatives to cover specific needs over short periods.

Futures and Options Fund (FOF) and Geared Futures and Options Fund (GFOF)

A futures and options fund is a scheme dedicated to approved and other derivatives. Most of the transactions must be fully "covered" by cash, securities or other derivatives. Such a fund may or may not contain transferable securities.

A geared futures and options fund is a scheme dedicated to approved and other derivatives. Most of the extent of investment is limited by the amount of property available to be put up as "initial outlay". Such a fund may or may not contain transferable securities.

In the case of both FOFs and GFOFs, the regulators expect that futures and options will be used as part of the general investment management policy for the funds, not just as a more efficient way of buying or selling the underlying equities or bonds, as in the case of EPM for securities funds. Indeed, in a mirror image of the securities fund, it is expected that these two types of fund will spend most of their time investing in derivatives with the occasional foray into the underlying equity or bond. Derivatives can be held for the long term and rolled from one contract month to the next. Whilst there are no specific rules governing the degree of gearing to be used in either fund, it is expected that FOFs, unlike GFOFs, would have no, or a very low gearing.

Futures and Options Funds (FOFs)

Restrictions governing the use of derivatives in FOFs centre on the concept of "cover". Under the EPM rules, if a fund creates a liability or potential liability to receive or purchase stock, it must always have sufficient funds available to pay for such purchase; alternatively, if the fund creates a liability or potential liability to deliver stock, it must always have sufficient quantities of that stock available ready for delivery to the relevant counterparty. The concept of "cover" extends this definition to allow derivatives to cover derivatives in certain circumstances. In addition, FOFs are allowed to spend up to 10% of the fund on bought options which do not have cover - reflecting the lower risk factor in buying options rather than selling them. In both these cases, however, there are further safeguards ("set-aside") to stop the fund becoming highly geared. FOFs are permitted to borrow up to 10% of the fund and use such borrowing for cover also.

Finally, other important considerations for a FOF include the fact that cover cannot be used twice; there is a limit to how much of the cash holding in the fund can be deposited with any individual bank; and there is also a limit on how much of the fund can be exposed to any individual OTC counterparty.

Geared Futures and Options Funds (GFOFs)

Restrictions governing the use of derivatives in GFOFs centre on the concept of "initial outlay". Up to 20% of such a fund can be invested in initial outlay, which, put simply, can be thought of as bought option premium and initial margin on futures contracts or sold options. As in the case of a FOF, 10% of the fund can also be spent on bought options without requiring cover, but set-aside considerations still apply. The 10% number is in addition to the 20%, but any set-aside calculated is included in the 20%, again to prevent large quantities of low-priced options being purchased. However, in contrast to FOFs, no borrowing is permitted in a GFOF.

Insurance Funds

The regulations governing the use of derivatives in UK insurance funds are closely based upon those for "securities funds", that is on "Efficient Portfolio Management". The DTI has widened the definition, however, because of the longer-term nature of the funds being managed. Therefore, EPM for an insurance fund would permit in certain circumstances, derivatives providing "cover" for other derivatives, which would only be allowed under unit trust regulations for a FOF.

Pension Funds

We mentioned earlier that there are no formal investment guidelines affecting the use of derivatives in pension funds in the UK. Nevertheless, in our opinion, trustees should base their own set of guidelines on the above EPM principles.

Crime and Punishment

The regulations governing the use of any investment instrument in a unit trust are strict and any rule-breaking will be punished by a fine and, potentially, compensation for the unit holders. In contrast, any rule-breaking in an insurance fund could be punished by the imposition by the DTI of a "provision for adverse variation" - effectively reducing the asset side of the balance sheet compared to the liability side and so reducing, or perhaps even removing, the fund's solvency margin - a very embarrassing occurrence for an insurance company.

In both cases therefore, it is vital for fund managers, compliance officers and members of the Board to have an understanding of derivatives and how they can affect the investment performance of the funds under management. If the equity market fell by 20% one month, the Board would expect the equity holdings to fall by a similar amount; it should have a similar understanding of the broad thrust of its derivatives strategy - e.g. "if the market fell by 20% in the next month, the portfolio would fall by only 15%, derivatives protecting the portfolio to that degree."

The Practicalities

Now that the new regulations are in place, how are investment institutions responding to them? Volume of trading on LIFFE, the London International Financial Futures and Options Exchange, is growing inexorably, reflecting the increasing usage of derivatives by UK fund managers.

The major practical usage of derivatives, in our opinion, is for the transfer of assets from one category to another - e.g. bonds to equities - or from one region to another - e.g. US equities into UK equities. But there is a danger that mistakes can be made without efficient controls. The fund manager can effect a transfer out of the US equity market by selling S&P futures contracts, but he would be unwise then to sell the underlying equities as well. Yet, if the controls are insufficient this error can easily occur in a busy investment management department. Close cooperation will be required between the compliance function, settlement department and the investment manager in order to design the control process. More importantly, there is little point in having state-of-the-art procedures if nobody is checking the output frequently.

Education of relevant members of staff from the top of an organisation to the bottom is a vital part of the control and compliance process. The more people watching for potential rule breaches, the more likely they are to be spotted before they become a major problem. Such education should include not only the theory of the use of derivatives, but also the practical side of how to interpret the reports being generated. These reports should be sufficient for the fund manager to monitor her positions, for the Chief Investment Officer to monitor the fund management activity, for the Compliance department to check whether the investment guidelines are being obeyed and for the Board to be able to fulfill its statutory obligations of control.

The most important, yet most basic, control to put in place is to monitor derivatives in terms of the underlying exposure, not in terms of their profits or losses and certainly not in terms of their margin flows. Yet upon visiting most companies who are starting to use derivatives, it is our experience that, whilst they expect to look at their equity and bond holdings in terms of performance compared to an index, they still look at their derivatives performance in terms of profit and loss. This would only make sense if the institution was involved in trading derivatives - and if they are they should stop! An investment manager has to decide on the strategy which is behind her desire to use derivatives, then report it reflecting performance against that strategy. Only then can the Board make a sensible decision on whether derivatives are adding value to portfolios or not.

Other controls might focus on;

preventing stock being lent to marketmakers for extended periods when short-dated call options have also been sold on the same stock;

ICI shares being sold, but a long put option in ICI shares retained;

whether the fund is becoming geared through the use of derivative strategies;

ensuring that the currency hedging is appropriate.

Future Potential

As mentioned in the introduction to this article, UK unit trust managers now have a sensible, structured set of rules covering the use of innovative instruments such as futures and options. The rules for efficient portfolio management have, very recently, been used to form the basis for a similar set of rules covering the use of derivatives by life insurance companies. Prudent pension fund managers use similar principles to control the use of derivatives in their funds. A much greater flexibility has been given to all fund managers in the control of their portfolios.