Portfolio Surprise: Many Americans Run Hidden Financial Risk From `Derivatives' --- Exotic Investment Contracts Increasingly Permeate Pension, Mutual Funds --- Big Bets and High Leverage
When the securities first showed up in a brokerage-firm confirmation statement for the account of an elderly widow, John S. Leech recalls thinking they looked "odd."</br></br>"I'm accustomed to looking at confirmation statements, and I didn't understand what it was," says Mr. Leech, a Smith Barney broker in Fort Lauderdale, Fla., who was serving not as the widow's broker but as trustee of her $500,000 portfolio. The securities -- some 20% of the portfolio -- were listed as triple-A-rated bonds issued by a quasi-federal-government agency. There weren't any obvious risks.</br></br>But risky they were. While most bond prices were rising, the value of these securities plummeted about 50% in just seven months, wiping out 10% of the widow's portfolio. Mr. Leech, who is battling with lawyers to recoup the loss from her independent investment adviser, didn't realize the securities were a form of "derivatives" -- strange, hybrid investments that look like one thing and act like another. Once used solely by sophisticated financial institutions, derivatives have mushroomed in the past decade and are surfacing in the investment mainstream.</br></br>Many Americans are far more involved in derivatives than they realize. Their pension funds, mutual funds and insurance companies are knee-deep in the market, and wading in further.</br></br>"Most buyers of fixed-income mutual funds, for example, already own derivatives indirectly, whether they know it or not," says Kenneth Sullivan, who heads the derivative-products group at Republic National Bank of New York. Fixed-income, or bond, funds in the U.S. have some 12 million individual shareholders and $673 billion of assets.