Jurnal 5

The Use of Derivatives by Investment
Managers and Implications for Portfolio

Performance and Risk
Kingsley Fong
David R. Gallagher
Aaron Ng*
School of Banking and Finance, The University of New South Wales,

Sydney, N.S.W. 2052 AUSTRALIA
ABSTRACT
This study provides an empirical examination of derivative instruments used by

institutional investors. Our analysis provides a unique insight into the role of
derivative securities within portfolios, and the potential benefits from their use. We
contribute to the literature using a database that comprises the periodic portfolio
holdings and daily trades of active equity managers. The consequence of derivative
use is analysed using a number of performance and risk measures. Overall, we find
the use of derivatives have a negligible impact on fund returns. This finding is
attributed to low levels of derivative exposure relative to total fund size. We also
evaluate how derivatives are used by considering the trading strategies executed by
investment managers. The option trading patterns of active institutional investors are
shown to be consistent with the execution of momentum trading strategies. The study
also documents that active investment managers prefer not to use options markets to
engage in informed trading.
JEL classification: G11, G23
Keywords: Derivatives, Managed Funds, Investment Performance, Portfolio Risk
* Corresponding author. Email: aaron.ng@unsw.edu.au 1

The Use of Derivatives by Investment
Managers and Implications for Portfolio
Performance and Risk
ABSTRACT
This study provides an empirical examination of derivative instruments used by

institutional investors. Our analysis provides a unique insight into the role of
derivative securities within portfolios, and the potential benefits from their use. We
contribute to the literature using a database that comprises the periodic portfolio
holdings and daily trades of active equity managers. The consequence of derivative
use is analysed using a number of performance and risk measures. Overall, we find
the use of derivatives have a negligible impact on fund returns. This finding is
attributed to low levels of derivative exposure relative to total fund size. We also
evaluate how derivatives are used by considering the trading strategies executed by
investment managers. The option trading patterns of active institutional investors are
shown to be consistent with the execution of momentum trading strategies. The study
also documents that active investment managers prefer not to use options markets to
engage in informed trading.
JEL classification: G11, G23
Keywords: Derivatives, Managed Funds, Investment Performance, Portfolio Risk
2
1. INTRODUCTION
Recent decades have witnessed a dramatic shift in the nature of risk in global
financial markets, in which the volatility of many asset classes has increased.1 In an
environment in which investors are continuously exposed to a broad range of dynamic
risks, derivatives have become a valuable tool used in the risk management practices
of institutions. As a product of developments arising from the literature, derivative
markets have experienced significant growth in both the size and scope of the
securities available to traders.2 These innovations have provided users with a wide
range of alternatives in managing their financial market exposures.
Despite the potential for derivatives to effectively manage the risks faced by
institutions, public opinion concerning these instruments suggests the general public
view derivative securities as inherently dangerous (McGough (1995)). This view has
been argued to have arisen due to the recent high-profile corporate losses that have
been attributed to derivative use, as well as recent episodes of rogue trading scandals.
Such examples include Long–Term Capital Management (LTCM) in the U.S.,
Barings Bank in the U.K., and the recent foreign exchange episode at National
Australia Bank. These anecdotes highlight the potential hazards of derivative use, and
have attracted the close attention of risk management executives, investors,
governments and market regulators, as well as the media.
In attempting to prevent corporate failure resulting from the use of derivatives,
regulators have generally approached the matter from a disclosure perspective.3
1
Campbell, Lettau, Malkiel, and Xu (2001) document the upward trend in idiosyncratic volatility in
equity markets. Gross (1997) also notes the increase in the volatility of U.S. bond yields.
2
Seminal papers include Black and Scholes (1973), the binomial option pricing model by Cox, Ross,
and Rubinstein (1979), American option pricing methods by Baroni-Adesi and Whaley (1987), pricing
of compound options by Geske (1979), and the constant elasticity of variance (CEV) model by Cox
(1975).
3
Accounting regulators have formulated standards which require the disclosure of nominal contract
exposures and fair value of derivative instruments in financial accounting statements.
3
Regulation of derivative use in the Australian investment management industry has
not required quantitative disclosure, but rather the design and implementation of risk
management policies, and constraints on the use of derivatives.4 The Australian
Prudential Regulation Authority (APRA) prescribes that derivatives may not be used
for speculative purposes, and funds may not hold uncovered positions in derivatives.
Derivative use must also be conducted within the confines of the trust deed.5
Theoretical literature proposes that derivatives provide users with efficiency
benefits, in the form of reduced transaction costs and improved risk control (Merton
(1995)). Despite these alleged benefits, several studies from both the corporate and
investment management literature (Hentschel and Kothari (2001), Koski and Pontiff
(1999)) have found that the risk and return characteristics of derivative users are
indeed similar to that of non-users. This gives rise to an apparent puzzle of why
institutional investors might use derivative instruments. If derivatives provide no
observable benefit in terms of either portfolio performance or risk, then one may
question what the purpose of derivatives really is. This intuition also raises further
questions as to why market participants continue to engage in large volumes of
derivative transactions.
The primary contribution of this study is to better understand how derivatives
are used by institutional investment managers. The extant literature on derivative use
has largely focussed on corporate hedging, which is likely to display considerable
differences from the use of derivative instruments within the investment management
4
For a detailed discussion of risk management practices in the Australian investment management
industry, see Brown, Gallagher, Steenbeek, and Swan (2005). The governance mechanism is most well
known among superannuation funds, which are required to maintain a Part B Risk Management
Statement (RMS) outlining their response to how risks are monitored.
5
APRA Circular (No. II.D.7)
4
industry.6 There are only a few studies which directly analyse the use of derivatives
by investment managers. Koski and Pontiff (1999) examine the distribution of mutual
fund returns partitioned according to whether derivatives are used or not, and they
conclude that derivatives do not lead to significant differences in performance or risk.
Pinnuck (2004) shows that Australian equity managers utilise options to both increase
or decrease exposure to underlying stocks held in the fund, however Pinnuck (2004)
does not attempt to infer the motivation for derivative use by portfolio managers. The
empirical literature has therefore been unable to characterise how derivatives are used
by investment managers, and our study therefore approaches this issue with respect to
the trading strategies executed by managers in derivative securities.
This study benefits significantly from a unique and confidential dataset of
equity manager transactions and holdings. Prior studies examining U.S. funds have
typically analysed the portfolio holdings of investment managers observed at quarter-
end periods, where this data only includes equity holdings and not other instruments
such as derivatives (Moskowitz (2000)).7 To evaluate the use of derivatives, Koski
and Pontiff (1999) conduct telephone interviews to determine whether or not mutual
funds are permitted to trade derivatives, however this binary approach is unable to
capture the size of derivative exposures held by funds. While the data used by
Pinnuck (2004) includes the month-end holdings of options, the sample did not
include data showing holdings of futures contracts. Our study offers a significant
improvement to Pinnuck (2004) given our database contains the month-end portfolio
holdings and daily trades of all securities, including derivatives, and also investigates
derivative use in considerably finer detail.
6
While the motivation to use derivatives as a part of a risk management strategy still exists for
investment managers, derivatives also represent a direct alternative to investment in underlying asset
markets.
7
The portfolio holdings of U.S. institutional investors have been derived from 13F disclosure forms
reported on a quarterly basis to the Securities & Exchange Commission (SEC).
5
In evaluating the impact of derivatives on the returns of active equity
managers, tests are employed to measure the differences in the distributions across a
range of widely used performance and risk measures (see Koski and Pontiff (1999)).
Consistent with the literature, we document few observable differences in either
performance or risk between derivative users and non-users. We attribute this result to
the low level of derivative exposure relative to the total size of fund portfolios.
We next examine the propensity for active equity managers to transact in
options on stocks exhibiting momentum by analysing the proportion of option trades
on stocks whose future price movements are expected to follow momentum patterns.
Investment managers are shown to uniformly avoid trading options on stocks with
relatively poor past returns, while some funds also trade disproportionately heavily in
options on stocks with relatively strong past price performance. This provides
empirical support that investment managers indeed use options to capture momentum
returns. We also examine the information content of option trades by active equity
managers and document no abnormal price movements in the underlying stocks over
short-run event windows, both immediately prior and subsequent to option trades. We
interpret these findings as evidence that investment managers do not execute informed
trading in options markets.
Overall, this study provides evidence that the trading strategies that are widely
known to be implemented in stock markets are also executed using option securities.
Contrary to public perception that derivatives are inherently risky financial
instruments, our results confirm previous academic research that the use of derivatives
by institutional traders does not lead to significant differences in the performance or
risk between derivative users and non-users.
6
The remainder of the paper is structured as follows. Section 2 summarises the
relevant extant literature and formulates the hypotheses that are addressed in this
paper. Section 3 outlines the empirical methodologies employed in testing the
hypotheses. Section 4 presents the results and provides a discussion of the key
findings. The final section concludes.
2. HYPOTHESES
Derivatives provide potential benefits through reduced transaction costs, both
explicit costs of trading (in imperfect markets) and implicit costs such as liquidity-
motivated trading. Conversely, the potential costs of derivative use arise from the
leveraged exposure to market risks, which may be exploited by investment managers
in response to agency incentives.8 However, little empirical evidence exists to verify
the actual costs and benefits that arise from the use of derivatives.
H1: The use of derivatives causes significant impacts on the performance
and risk of Australian investment managers.
Since the payoffs of equity derivatives are determined by the performance of
the underlying share price, they may be used as alternatives in implementing equity
trading strategies. In particular, this study focuses on the momentum strategy outlined
by Jegadeesh and Titman (1993). Previous studies have shown that mutual funds do
engage in momentum strategies in their equity stock holdings.9
Several factors in the Australian institutional environment make derivatives
potentially more appropriate than shares in implementing momentum strategies. The
sale of poorly performing stocks triggers a capital loss, which may be undesirable if
8
Brown, Harlow and Starks (1996) and Chevalier and Ellison (1997) find that fund flows are
significantly driven by past fund performance, which creates incentives for investment managers to
adjust portfolio risk in order to maximise expected funds-under-management.
9
See Grinblatt, Titman and Wermers (1995) and Carhart (1997).
7
the fund is forced to offset the loss against long-term capital gains.10 Regulations
restricting fund borrowings prevents a manager’s ability to short-sell downside
momentum stocks, or purchase upside momentum stocks where a fund is at full
investment. Also, funds are often mandated to invest a minimum proportion of fund
assets in specified markets.11 This hinders the ability of a fund to sell stocks
exhibiting downside momentum. In each of these circumstances, derivatives may be
used to gain exposure to expected price momentum, overcoming constraints in
underlying stock markets.
H2: Active investment managers are using options markets to implement
momentum-based trading strategies.
Investment managers, through their skills in stock selection and market timing,
are theoretically able to generate private information which it may use to trade and
gain abnormal returns. Prior studies have found mixed evidence of informed trading
in option markets at an aggregate market level;12 however, there is no evidence to
support informed trading in options at an individual stock level.
Option contracts provide leverage and inherent insurance, which will be
desirable to an informed trader. Further, Share Price Index futures provide traders
exposure to an underlying asset that is not directly tradeable.
H3: Active investment managers are using options markets to engage in
informed trading.
3. EMPIRICAL METHODOLOGY
3.1 Data
10
In Australia, capital gains tax is only paid on 50% of the total long-term capital gains amount.
Capital losses are offset against total capital gains, which erodes tax benefits from long-term holdings.
11
This floor is commonly set at 90% of a fund’s total net assets.
12
Easley, O’Hara, and Srinivas (1998) show that option volumes lead stock prices, whilst Chakravarty,
Gulen and Mayhew (2004) provide evidence of price discovery in options markets.
8
We study Australian equity funds sourced from the Portfolio Analytics
Database. This unique database, containing month-end portfolio holdings and daily
trading data, was formed on an invitation basis to the largest investment managers
operating in Australia.13 The sample period for this study is 1 January 1993 to 31
December 2003. Further details concerning the construction of the database can be
obtained from Brown et al. (2005), Gallagher and Looi (2005) and Foster et al.
(2005). These studies also show that the sample of funds drawn from the database is
not significantly different from the universe of funds in terms of performance.
In addition to the managed fund data, daily stock price data and details of
dividends paid are collected from the SEATS system, sourced from the Securities
Institute Research Centre of Asia-Pacific. The All Ordinaries Accumulation Index
was used as the market proxy, whilst the Reserve Bank of Australia short interest rate
was used as the risk-free rate.14
The initial sample consists of 48 equity funds, across all fund styles. We
sample only actively managed funds that have the discretion to trade in derivatives.
There are no exchange traded derivatives listed on shares of companies outside of the
largest 100. Therefore we exclude index funds, enhanced passive funds and small-cap
equity funds. Of the remaining 34 funds, 50% are classed as derivative users.15 Value
funds accounted for 11 of the total sample funds, of which 3 were derivative users.
Growth-At-a-Reasonable-Price (GARP) funds represented 9 of the sample funds, of
which 5 were derivative users.
Table I reports descriptive statistics of the month-end portfolio holdings by
security type across the sample of active equity funds. We convert all derivative
13
The size of investment managers was measured by total funds under management.
14
The daily compounded RBA cash rate was converted to a continuously compounded annual rate.
15
A derivative user was defined as a fund that had holdings of derivatives any time during the sample
period.
9
contracts into dollar exposures before computing a fund’s percentage holdings. In
computing the mean values we first calculate, for each fund, the mean number of a
particular type of securities held across month ends, and then we take the mean of
these fund specific values. For instance, in Panel A the low number of call options
relative to the number of stock holdings shows that managers do not hold diversified
portfolios of options. N less than 1 shows that there are months in which funds have
no option holdings at all.
Panel B and Panel C contrast the holdings of derivatives users and non-users
and shows that whilst derivative users still hold large exposures to stocks for which
there are options, the size of exposures to these stocks taken by non-users are smaller
as a proportion of the fund. This suggests that derivative users utilise options as a
direct alternative to taking exposures in stock markets. At any given time, derivative
users hold positions in a small number of different futures contracts, suggesting that
holdings in futures are confined to single maturities. This may also imply that since
futures holdings are limited to few maturities, contracts are rolled-over as they
mature. Across the entire sample, funds trade only in Share Price Index futures, and
do not trade in individual share futures. Funds are on average net short in call options
when measured at the market price, providing some evidence that they are writing call
options to generate income.
Table II reports descriptive statistics of the daily trading data for the sample
funds. The distribution of average trade value is considerably positively skewed
across all securities. This suggests that managers occasionally trade in significantly
large parcels in stock, futures, and options markets. The number of trades per month
exhibits similar trends to the average trade value, being highly positively skewed,
suggesting that funds experience months of significantly large trading activity in
10
stock, futures, and options markets. The distribution of time to maturity of derivatives
is relatively symmetric. Degree of moneyness shows that option trades are relatively
close-to-the-money, however the median call trade is slightly out-of-the-money and
the median put option trade is slightly in-the-money. The high standard deviation of
moneyness for call options is consistent with the purchase of Low-Exercise-Price-
Options (LEPOs), which have a high degree of moneyness (close to 100%). In
addition, funds may be writing out-of-the-money call options, which have a low
degree of moneyness, providing further evidence of selling call options to generate
income.
3.2 Research Design
3.2.1 Risk metrics
We use a broad range of risk measures to capture distinct elements of risk.
These metrics include the variables examined by Koski and Pontiff (1999) and
additional variables as proposed by other studies.
Distributional parameters characterise the performance and risk of a fund
relative to the fund’s mean return. The first four moments of the fund return
distribution are examined.
Market model parameters are used as measurements of fund performance and
risk relative to market factors. The alpha and beta of each fund are derived from a
single factor model, and idiosyncratic risk calculated as the standard deviation of the
residuals.16 In addition, a market timing variable is included to capture the ability of
managers to utilise portfolio insurance to protect the portfolio against adverse market
conditions.
16
The single-factor model is estimated from the equation rt − r f ,t = α + β (rMkt ,t − r f ,t ) + ε t , where rt is
the return for month t, r f ,t is the risk-free rate at the end of month t, and rMkt ,t is the ex-post return on
the market during month t. A continuously compounded RBA cash rate is used to proxy for the risk-
free rate, and the logarithmic change in the All Ordinaries Index used as a proxy for the market return.
11
Sortino (2001) stresses the importance of considering the risk of falling below
a “minimal acceptable return” (MAR). A downside risk metric is included to capture
both the likelihood and magnitude of underperforming the relevant benchmark
return.17
3.1.2. Classifying momentum trades
In order to analyse the proportions of trades that follow momentum patterns,
each trade must be classified as a momentum or non-momentum trade. Jegadeesh and
Titman (1993) show that stocks exhibit persistent returns based on past 3-to-12 month
performance. Carhart (1997) shows that the persistence of mutual fund performance is
attributable to the 12-month momentum effect. For this reason, this study defines
momentum based on past 12-month performance. Recent studies, such as Badrinath
and Wahal (2002), continue to use momentum windows ranging from 3-to-12 months.
Demir, Muthuswamy, and Walter (2004) find significant momentum effects in
Australian equities over both short-term (1-week to 1-month) horizon, and
intermediate-term (3-to-12 month) horizon. Therefore, the 12-month momentum
effect should provide trading opportunities to investment managers where it may be
appropriate to transact in options markets.
To derive momentum rankings, the constituents of the All Ordinaries Index
are taken at each month-end of the sample period. Taking these constituents at each
month-end captures the entry of new firms into the market, and removes firms as they
are delisted from the ASX. The 12-month buy-and-hold return is calculated for each
stock at each month-end date, which is then used as the basis of ranking.
1
Downside risk is defined by the equation  (R − MAR )2 Pr  , where Rt is the return of the fund
17 MAR 2
∑ t t 
 −∞ 
during month t , MARt is the minimal acceptable return for month t , and Pr is the probability
associated with observing that level of return. The MAR for each month is set at the return on the All
Ordinaries Accumulation Index
12
Two alternative classifications of momentum are defined. Jegadeesh and
Titman (1993) construct a zero-cost trading strategy to profit from the momentum
effect, which involves buying a portfolio of stocks consisting of the top decile firms
based on past performance, and selling a portfolio of stocks consisting of the bottom
decile of firms. Therefore, stocks in the “Loser” portfolio are firstly defined as firms
in the bottom decile of the performance ranking, while stocks in the “Winner”
portfolio are defined as firms in the top decile of the performance ranking. As an
alternative measure, the “Loser” portfolio is also defined as the bottom quintile of
firms, and the “Winner” portfolio defined as the top quintile of firms.
Individual options trades are then classified as either loser momentum trades,
winner momentum trades, or non-momentum trades. Loser momentum trades are
options on any underlying stock that fell within the loser portfolio as at the previous
month-end date. Similarly, winner momentum trades are option trades on any
underlying stock that fell within the winner portfolio as at the previous month-end
date. Non-momentum trades are all remaining trades which were not considered
winner or loser trades.
The momentum strategy proposed by Jegadeesh and Titman (1993) profits
from upside exposure to the winner portfolio, and downside exposure to the loser
portfolio. Options provide linear price exposure to either upside or downside price
movements. Furthermore, options may be both written or bought, providing opposite
price exposures. Therefore, the sample of option transactions are separated by both
call option and put option trades, and by buy trades and sell trades. This yields a total
of four trade types. In addition to this, two trade types are defined in order to capture
similar exposures gained by different trade types:
13
1. Delta increasing trades are transactions that profit from upside price changes
in the underlying stock, and consist of call option buy trades and put option
sell trades; and
2. Delta decreasing trades are transactions that profit from downside price
changes in the underlying stock, and consist of call option sell trades and put
option buy trades.
The total number of option transactions for each trade type in the loser, winner
and non-momentum categories are calculated for each fund over the entire sample
period. These totals form the basis of the tests of proportions. For each fund, the
distribution of trades over the three categories is compared against the expected
number of trades in each category using a chi-squared goodness-of-fit test.
For the goodness-of-fit tests over decile-based momentum trades, the expected
number of trades in winner and loser categories are each equal to 10% of the total
number of option trades, while the expected number of non-momentum trades is equal
to 80% of total option trades. Similarly for the goodness-of-fit tests over quintile-
based momentum trades, the expected number of trades in winner and loser categories
are each equal to 20% of the total number of option trades, while the expected number
of non-momentum trades is equal to 60% of total option trades.
Tests of the nominal number of trades will not incorporate relative differences
in trade size, and the level of exposure generated by each trade. For this reason, a
measure of the value-weighted number of trades is introduced. This variable is
calculated for each trade category as:
Total exposure of tradesi (1).

Value − weighted number of tradesi = Total number of tradesi × k
∑ Total exposure of trades

i =1
i
14
The exposure of each trade is calculated as the equivalent ordinary share exposure
(see Appendix). The chi-squared goodness-of-fit tests are then conducted, as
described, over the value-weighted number of trades.18
3.1.3.Event study of option trades
The literature approaches the use of options for informed trading at a market
level, by comparing aggregate variables such a prices and volumes between stock and
option markets. Much of this literature has utilised high-frequency intraday data to
establish lead/lag relationships between option and stock markets, finding mixed
support for informed trading using options. Easley, O’Hara and Srinivas (1998) show
that price changes in stock markets lead option volumes with a lag of 20 to 30
minutes, whilst option volumes affect stock price changes more rapidly. Jarnecic
(1999) shows that stock volumes on the ASX lead option volumes on the ASX
Options market. Cairney and Swisher (2004) represent one of few studies which
analyse informed trading in options markets on a lower-frequency basis, showing
abnormal volume in Chicago Board Options Exchange (CBOE) options for three days
prior to earnings announcements.
This study benefits from high granular data comprising the daily transactions
in option securities on the Australian Stock Exchange Derivatives market (ASXD) by
institutional Australian equity investment managers. As such, the tests employed in
evaluating informed trading are not confined to market level analysis, and therefore
enables an assessment of the information content for individual trades by specific
market participants. Importantly, prior studies have found evidence that mutual funds
possess private information (Daniel, Grinblatt, Titman, and Wermers (1997),
18
In order to ensure that the chi-squared distribution adequately approximates the discrete sampling
distribution, the goodness-of-fit tests must conform to the rule of five. As a consequence, funds with an
insufficient number of trades were excluded from these tests (less than 50 trades for decile-based tests,
and less than 25 for quintile-based tests). Across all option trade types, 8-to-9 funds were excluded
from the decile based tests, and between 3-to-8 funds were excluded from the quintile based tests.
15
Wermers (2000)). Therefore, this study provides an evaluation of the decision to
disseminate private information in options markets as opposed to stock markets.
The information content of investment manager option trades is assessed by
examining the behaviour of the share price of the underlying stock, both before and
after option transactions are executed. An event study methodology is employed to
measure the significance of share price movements around a specific period in time,
for which an event is defined as an option trade by an active investment manager.
Standard event study methodologies typically pool abnormal returns across all
observed events, and test the hypothesis that the mean abnormal return is equal to
zero (Kritzman (1994)). This approach is inappropriate in this study for several
reasons. Firstly, there are many factors influencing the decision by investment
managers in choosing to transact in options markets, such as equitising fund flows,
attempting to add value through hedging, or by implementing trading strategies based
on public information.19 Thus, not all option trades will be motivated by acting upon
private information. Pooling option trades will create significant noise in the event
study model by including trades initiated by different motivations, and may distort the
underlying share price impacts of option trades. Secondly, since options are short-
term trading instruments (given that they are financial contracts with expiry dates),
investment managers are likely implement further trades to reverse initial trading
positions. The timing of this reversal trade will be influenced by factors other than
information motives, such as managing the loss of time value of the option exposure.
This effect also prevents a pooled analysis of investment manager option trades. To
overcome these issues we study the underlying share price behaviour around option
trades at daily intervals.

19
Trading on the basis of public information will not result in any abnormal share price reaction in the
underlying stock. An example of a trading strategy based on public information is the momentum
strategy, where the trading decisions are formed solely on historical performance.
16
To implement the event study, daily abnormal returns are calculated from 10
days prior to the option trade, to 10 days subsequent to the option transaction. For
each day, the market-adjusted abnormal return is calculated as the difference between
the daily simple compounded return on the stock minus the contemporaneous daily
return on the All Ordinaries Accumulation Index.20 Cumulative abnormal returns for
the post-event windows are then formed by summing the abnormal returns across
each relevant event days.
k
CARt ,t + k −1 = ∑ ( Rt + j −1 − RMkt ,t + j −1 ) (2),
j =1
where CARt ,t +k −1 = the cumulative abnormal return from day t to t + k − 1
Rt + j −1 = the return on the underlying stock on day t + j − 1
RMkt ,t + j −1 = the return on the All Ordinaries Index on day t + j − 1
k = 1, 3, 5, 10.
Cumulative abnormal returns for the pre-event windows are formed exclusive of the
return on the day of the option trade.
k
CARt −k ,t −1 = ∑ ( Rt − j − RMkt ,t − j ) (3),
j =1
where CARt − k ,t −1 = the cumulative abnormal return from day t − k to t − 1
Rt − j = the return on the underlying stock on day t + j
RMkt ,t − j = the return on the All Ordinaries Index on day t + j
k = 1, 3, 5, 10.
For each event date, we estimate the standard deviation of returns as the
square root of the sample variance of returns from t − 100 to t − 11 , where t is the
20
Daily stock returns are adjusted for dividends and capital distributions.
17
day of the option trade. The estimation of the standard deviation prior to the event
window ensures that estimates of the standard error are not biased by the effects of the
event. The standard error for each event window is then calculated as:
s.e.(CARt ,k ) = σ t −100,t −11 k (4),
where s.e.(CARt ,k ) = the standard error on day t for a k -day event window.
σ t −100,t −11 = the standard deviation of daily stock returns, calculated
from day t − 100 to t − 11 .
k = the length of the event window, taking the values of 1,
3, 5, and 10.
For option trade, the test statistics for post-event windows are calculated as:
CARt ,t + k −1
Z= (5),
s.e.(CARt ,k )
Similarly for pre-event windows, the test statistic is:
CARt − k ,t −1
Z= (6).
s.e.(CARt ,k )
This test statistic follows a standard normal distribution, and tests the null hypothesis
that the cumulative abnormal return equals zero.
4. RESULTS
4.1. Distributional moments and risk measures
4.1.2. Results of difference-in-means tests
18
[Insert Table III here]
Table III presents the results for the difference in cross-sectional mean tests
for the distributional moments and risk measures. Broadly, these tests do not identify
any significant differences in the performance or risk between funds that use
derivatives and those that do not.
Panel A of Table III shows that during the sample period, active equity funds
yield positive mean returns that are negatively skewed and leptokurtic. This is
consistent with previous studies that have found similar non-normality in the return
distributions of equities and fixed income funds in Australian and international
markets (Bird and Gallagher (2002)). Across the entire sample of funds, derivative
users display insignificantly higher mean returns, and insignificantly lower standard
deviation, skewness and kurtosis. In the subsets of fund styles, Growth and Growth-
At-a-Reasonable Price (GARP) funds show the same trends as the full sample. Value
funds using derivatives yield insignificantly lower mean returns than those that did
not use derivatives, and otherwise follow the trends found in the full sample. The
behaviour of Style Neutral funds opposed the trends of the full sample, with
derivative users yielding insignificantly lower mean returns, insignificantly higher
standard deviation, and were more negatively skewed and platykurtic. Therefore,
whilst these results are of the correct sign to suggest that derivatives improve
performance and reduce risk, they are of insufficient magnitude to conclude these
inferences with statistical significance.
Panel B of Table III shows that on average, funds display positive alphas.
Growth and GARP funds that did not use derivatives are the only group to derive
negative alphas. There is weak evidence indicating a difference in the mean alpha
between derivative users and non-users for Growth and GARP-style funds, with the
19
Wilcoxon rank-sum test significant at the 10% level. For Value and Style Neutral
funds, derivative users are documented as having insignificantly lower alphas. Higher
betas (measuring systematic risk) are found for Growth, GARP, and Style Neutral
funds that used derivatives, and lower mean beta for Value funds using derivatives.
Idiosyncratic risk is insignificantly lower for derivative users across all fund styles,
with the exception of Style Neutral funds. Timing beta is found to be negative across
funds on average, with derivative users showing insignificantly smaller negative
coefficients. GARP funds that did not use derivatives displayed a positive mean
timing beta, though insignificantly different to derivative users. Style Neutral funds
that use derivatives also display a positive mean timing beta, which is also
insignificantly greater than for non-user funds. Downside risk is insignificantly
smaller for derivative users across all fund styles except the Style Neutral category.
4.1.3. Results of difference-in-standard-deviation tests
[Insert Table IV here]
Table IV reports the results for the tests of difference in cross-sectional
standard deviation of distributional moments and risk measures.21 There is some
evidence that the dispersion of the performance and risk parameters between
portfolios that include and exclude derivative securities are different. Panel A of
Table IV reveals the standard deviation of all distributional moments are lower for
derivative users across all funds. The standard deviation of the mean is significantly
different in the test of all equity funds, however, the difference is only weakly
significant for GARP funds and insignificant for all other fund styles. This suggests
that the observed differences across the aggregate sample are attributable to cross-
sectional differences in fund style. The dispersion of the mean is significantly smaller
21
Cross-sectional standard deviation is computed by taking the standard deviation of the moment of
interest. Note that the standard deviation of mean here is different from the mean standard deviation in
Table III.
20
across all funds, which is largely driven by a lower dispersion of derivative users in
the Value funds category. GARP and Style Neutral funds also suggest evidence of
lower dispersion. The standard deviation of skewness is lower for derivative users
across all funds, but similar to the dispersion of the mean, is likely caused by
differences in fund style rather than derivative use. The dispersion of kurtosis is lower
for derivative users in the Growth, and GARP fund styles.
Panel B of Table IV provides further evidence for the dispersion of risk
between derivative users and non-users. The dispersion of alpha is insignificantly
lower for derivative users across Growth, GARP and Value funds, and insignificantly
high for Style Neutral derivative users. The significant difference in the standard
deviation of all funds is not robust after controlling for fund style. The standard
deviation of beta is mixed across fund styles, being lower for derivative users in
Growth and Style Neutral funds, and higher in GARP and Value funds. The
dispersion of idiosyncratic risk is significantly lower for All Funds and Growth funds
that use derivatives, and significantly higher for derivative users in the Style Neutral
category. Timing beta exhibits lower standard deviation for all fund styles except for
Style Neutral funds. Downside risk shows a generally lower dispersion for derivative
users, and is significantly lower for Growth funds.
4.1.4. Interpretation of results
The results in Table III show no systematic difference in the means of
distributional moments and risk measures. This result is consistent with the findings
of Koski and Pontiff (1999), who conclude that derivative use is not cross-sectionally
related to risk exposure and the higher moments of fund return distributions. We find
differences in the means of the parameters across fund style, but find no evidence of
significant differences between derivative users and non-users after controlling for
21
fund styles. We conclude that derivative use, on average, has no observed impact on
fund performance or risk.
The discussion for the descriptive statistics of fund holdings in section 4.1.3
observes that the size of derivative exposures is small as a proportion of the total
portfolio. Mean futures exposure represents 6% of portfolio exposure to derivative
users, and mean options exposures contributing to less than 1% of portfolio exposure.
This presents a likely reason for the lack of observed impact of derivative use on
performance and risk. Since investment managers are not engaging heavily in
derivative exposures, the effects of derivative use are masked by analysis of aggregate
fund performance and risk.
The results of Table IV add depth to the inference drawn from the analysis of
the mean values of performance and risk parameters in Table III. The use of
derivatives reduces the level of cross-sectional dispersion in each of the first four
moments of the distribution of returns. This suggests that active investment managers
are using derivatives for common purposes, causing the returns of these funds to
follow similar distributions. In particular, the lower dispersion in the standard
deviation and kurtosis of derivative user funds is symptomatic of portfolios
employing derivatives for hedging. Derivative use causes fund returns to be more
homogenous. The strongest relationship in the market-based risk measures is a lower
dispersion of timing beta for derivative users. This indicates that the use of derivatives
allows funds to respond to changes in the market, and consequently, positive market
movements have less impact on the fund’s market timing ability. As an alternative
explanation, the literature has established that fund flows initiate liquidity-motivated
trading, which creates a drag on fund performance (Edelen (1999)). During periods of
strong stock market performance, funds would experience large inflows. The use of
22
derivatives may assist in equitizing fund flows, which would reduce the impact of
liquidity-motivated trading following strong equity markets. The weak evidence of
lower dispersion of downside risk indicates that growth funds may be using
derivatives to manage exposures to downward price changes in stock markets.
4.2. Analysing the proportions of option trades
4.2.2. Results of goodness-of-fit tests
[Insert Table V here]
Table V presents the results of the chi-squared goodness-of-fit tests over the
equally-weighted proportion of option trades for stocks in momentum and non-
momentum portfolios. Broadly, funds on average trade disproportionately less
frequently in options over stocks in loser portfolios. There is evidence of some funds
trading more frequently in options over stocks in winner portfolios.
Panel A reports the empirical findings where momentum portfolios are defined
by upper and lower return deciles of the All Ordinaries Index. Across all option trade
types, there is evidence that active equity funds trade disproportionately in option
securities on momentum stocks. The chi-squared tests of goodness-of-fit (actual
versus expected proportions) are found to be significant for a substantial majority of
funds across all option trade types. This shows that the observed number of trades in
each category are significantly different to the expected number of trades. In
particular, active equity managers avoid exposure to the loser portfolio, as shown by
the shortfall in the observed proportion of trades in this category below the expected
proportion. The median proportion of trades in the loser portfolio is less than 2% for
all trade types. For call option trades, the median proportion of option trades in the
23
winner portfolio was less than the uniform expectation, suggesting that overall funds
are also avoiding upward momentum exposure. However, the maximum proportion of
buy trades in call options over the winner portfolio was 18.4%, signifying that some
funds use options to generate exposures to winner momentum stocks. In contrast, the
small proportion of put option trades over winner stocks shows that these options are
inappropriate in gaining upward momentum exposure.
Panel B presents the results of the momentum portfolios which are defined by
upper and lower quintiles. These results provide stronger evidence that active equity
funds trade disproportionately in options on stocks which exhibit momentum
characteristics. Similar to the decile-based ranking results, the chi-squared goodness-
of-fit tests are significant for substantially all of the sample funds. This is largely due
to funds trading lower proportions of options over loser stocks. In contrast to the
decile based results, the majority of funds trade disproportionately in call options over
winner stocks, representing around 30% of the median fund’s trades. Furthermore, at
the maximum, funds place close to half of their call option trades over stocks in the
winner portfolio. The same phenomenon is less acute in put option securities, where
the median proportion of fund trades is close to the expected 20%, and the maximum
proportion is not substantially greater (at around 27%).
[Insert Table VI here]
Table VI reports the results of the chi-squared goodness-of-fit tests over the
value-weighted number of option trades for stocks in momentum and non-momentum
portfolios. These tests incorporate the relative size of each option trade, measuring the
value of each transaction as the equivalent ordinary share exposure. These results
24
confirm the findings of the equally-weighted momentum tests in Table V.
Substantially all equity funds trade disproportionately around these momentum
categories.
Panel A of Table VI shows that the value of option trades over stocks in loser
portfolios is substantially lower than expected, and to an even greater degree than for
the results of the equally-weighted proportions. Some funds are shown to completely
avoid portfolio exposures to loser stocks, as shown by the 0% minimum proportions
across call option trades, and for put option sell trades. The median value-weighted
proportion of trades over winner stocks is lower than the equally-weighted proportion,
providing further evidence that funds are, on average, also avoiding options exposure
to winner stocks. Further, there is evidence that some funds acquire exposure to the
winner portfolio using option securities, with the maximum proportion of trades over
winner stocks exceeding the expected value of 10%. Funds unanimously trade
disproportionately less in put options over winner stocks. This is consistent with the
findings of Pinnuck (2004), which show that funds prefer to hold stocks that are past
winners. Therefore, investment managers would not require the right or the obligation
to sell the stocks in their portfolio with strong past performance, making put options
redundant for this purpose.
The results in Panel B of Table VI exhibit the same characteristics of the
equally-weighted trade proportions, but are much more pronounced. For call option
trades, funds both under-invest in options over loser stocks, and over-invest in options
over winner stocks. The maximum proportion of loser trades is 10%, while the
maximum proportion of winner trades is 60-80%. The table clearly shows that funds
trade disproportionately higher volume in winner stocks. Put option trades show no
such effects, with the median fund trading close to the expected values.
25
4.2.3. Interpretation of the results
Overall, the goodness-of-fit tests reveal that funds trade relatively infrequently
in options over stocks with poor past performance, and relatively frequently in options
over stocks with strong past performance. These results may be interpreted as
showing that equity funds use options to gain exposure to “winner” momentum
stocks, and this is partially consistent with implementing a momentum trading
strategy. Disproportionately large trading in options over winner stocks is consistent
with a momentum trading strategy which requires taking long exposure in stocks with
strong past performance. However, investment manager trading behaviour in options
does not show signs of the opposing side of the momentum strategy that prescribes
taking short exposure in stocks with poor past performance. That is, the option trades
of investment managers are consistent with purchasing exposure to the winner
portfolio, but do not simultaneously sell exposure to the loser portfolio.
Although these results are consistent with momentum trading, they may also
be symptomatic of other forms of trading behaviour. As such, whilst the results are a
necessary condition of implementing momentum strategies, they are not a sufficient
condition to prove momentum trading.
One aspect which is not captured by these tests is the timing of option trades.
The timing of option trades is important in indicating the purpose of a particular trade.
That is, an option trade of opposite direction to previous trades in the same option
security may be performed to reverse out an exposure that the fund currently holds.
Since multiple trades are required to conduct a round trip into and out of an exposure
to an option security, this would inflate the relative proportion of trades over
particular stocks.
26
Another aspect that is not captured by the level of trading activity by fund
managers is the relative level of exposure to a particular stock which is currently held
in the portfolio. Jegadeesh and Titman (1993) show that the momentum anomaly is
evident over a 3-to-12 month holding period. Therefore, investment managers
attempting to implement a momentum strategy may simply buy-and-hold an exposure
to the momentum portfolios, and not trade continuously across these stocks. In these
circumstances, a test of trading activity will not consider the ongoing level of
exposure that a manager holds.
Despite the existence of possible alternative explanations, the tests employed
clearly identify a systematic trend that the options trades of investment managers are
cross-sectionally related to the past performance of the underlying stock.
4.3. Event study of option trades
4.3.2. Results of event study
[Insert Table VII here]
Table VII presents the results of the event study examining the impact of
investment manager option trades on underlying stock returns. These results show that
the options trades of investment managers are not as a response to, or do not trigger
abnormal share price reaction in the underlying stock. This suggests that the market
interprets little or no private information content in option trading.
The results shown in Table VII are the percentiles of the t-statistics for the
cumulative abnormal returns (CARs) in the underlying stock calculated for each
option trade. If investment managers engage in informed trading in options markets,
the information will quickly flow from the option price through to the price of the
27
underlying stock, driving abnormal stock returns around an option transaction. The
results in Table VII do not show such reaction. Whilst many of the 1st percentile and
99th percentile of the t-statistics are significant at the 1% level, this is not indicative of
abnormal share price reaction. The significance of the t-statistic reveals that the
likelihood of observing an observation of this magnitude is 1% probability. Since this
only occurs for less than 1% of the observations, the effects of an option transaction
are equivalent to a random stock price change, therefore this does not signify an
abnormal stock return. To demonstrate that some proportion of option trades contain
private information content, it is necessary to show a significant CAR for a proportion
of option trades substantially greater than the level of significance. We do not find
such evidence.
An interesting outcome of these tests, however, is the general consistency of
the sign of CARs for particular option trade types. Call option buy trades exhibit a
consistent positive mean CAR prior to an option trade, and a negative mean CAR
subsequent to an option trade. Call option sell trades display consistently positive
mean CARs during both pre-event and post-event windows. Put option buy trades
show a general trend of positive CARs around option trades, with only negative CARs
seen 3-to-5 days before the event. Put option sell trades show a consistently negative
CAR for all event windows, except for the 10 day post-event window. CARs around
Delta Increasing trades are negative immediately prior to and following and option
trade, and positive otherwise. CARs around Delta Decreasing trades are consistently
negative for all event windows.
4.3.3. Interpretation of results
The results of the event study suggest that there is no informed trading in the
options trades by active equity managers. This is a lack of observable abnormal share
28
price reaction around option trades. This result is consistent across all option trade
types.
At first instance, it appears that this result conflicts with some of the results
found in the prior literature (Easley, O’Hara, and Srinivas (1998), Chakravarty,
Gulen, and Mayhew (2004)). Previous studies have provided mixed support for the
operation of informed trading in options markets. Whilst it should be noted that the
issue of whether informed trading occurs in options markets is still unresolved, the
bulk of this research has been conducted on a market level. To our knowledge, this is
the first study to investigate informed trading in options markets conducted
specifically by investment managers, and which utilises a unique dataset of daily
institutional trading data. Thus, while some degree of informed trading may be
performed using options, the results of this study suggest that investment managers do
not transact in options markets as a means of trading on private information. This
implies that the informed trading in options markets found by prior studies is
conducted by traders other than active equity managers. Therefore, the findings of this
study complement the findings of the market level informed trading research (Easley,
O’Hara, and Srinivas (1998), Chakravarty, Gulen, and Mayhew (2004)) by identifying
a specific group of institutions that do not use options for informed trading.
The sign of CARs provides further insight into the trading behaviour of
investment managers. For call option buy trades, the mean CARs are steadily
decreasing from 10 days prior until the day of the event. The abnormal share price
return on the day of the call purchase is the largest negative mean return around the
period. The CARs steadily increase from the day after the trade. This suggests that
funds may be able to locate profitable opportunities to purchase call options during
days in which the share price has fallen. The behaviour after the trade may suggest a
29
stable correction in the market. Likewise, the mean abnormal return on the day of a
call option sell trade is positive, and largest in the days around the event. Investment
managers may be selling call options following a rise in the share price during the
day, since it would be seen as less likely to rise further and into a loss position for the
fund. The mean contemporaneous CAR for put option buy trades is positive, which
would be consistent with funds buying put options following a share price rise during
the day on the expectation of a future share price fall. Put option sell trades show an
opposite effect in the underlying share price, and is therefore consistent with selling
put options in expectation of a future share price rise. Overall, this contrarian
(liquidity provision) strategy in options trading better explains a manager’s motivation
in participating in the option market than simply a pure risk management or informed
trading explanation.
5. CONCLUSION
This study uses a unique and confidential database comprising the monthly
holdings and daily trades of investment managers to study derivatives use by active
fund managers. It contributes to the literature in two ways. Firstly, it provides
evidence showing that the use of derivatives in portfolios lead to no significant
difference in either the performance or risk across funds. Secondly it investigates
how derivatives are actually used by investment managers.
Our results generally shows insignificant differences in both performance and
risk across derivative users and non-users. This suggests that derivatives use by
investment managers does not achieve higher returns, or reduce portfolio risk relative
to other investment managers. However, the lower dispersion of these performance
and risk measures provides evidence that derivatives improve managers’ ability to
30
control fund risk, and leads to more homogeneity in fund returns. The small size of
derivative exposure relative to fund size limits the impact of derivatives on aggregate
fund portfolios.
We find evidence that investment managers trade disproportionately less in
options on stocks with relatively poor past price performance. Some funds are also
found to trade heavily in options on stocks with relatively strong past performance.
This observed option trading pattern is indicative of using options to generate
exposure to momentum stocks. In addition, the options trading behaviour is consistent
with prior research on fund manager stock trades (Grinblatt, Titman, and Wermers
(1995)).
No abnormal price movements in underlying stock prices are found in short-
term windows around the option trades of active investment managers. The lack of
market reaction suggests that options are not used to execute informed trades.
However this result is consistent with managers using option trading, particularly call
options, to capture short term contrarian opportunities.
31
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34
Table I
Descriptive Statistics of Fund Holdings
This table provides descriptive statistics of the month-end portfolio holdings sourced from Portfolio Analytics Database for
the period 1 January 1993 to 31 December 2003. Exposures are reported as a proportion of fund size. Contract exposure is
measured as the number of securities multiplied by the market price of the securities. The measurement of delta exposure
differs by security. For stocks, delta exposure is equal to contract exposure. For futures, delta exposure is equal to (number
of contracts x futures price x delta of the future). For options, delta exposure is measured as (number of option contracts x
number of shares per contract x spot stock price of the underlying asset x delta of the option). Figures are reported for net
holdings, long only, and short only positions. Stocks (All) refers to exposures to all holdings of stocks. Stocks (sub) refers
to the subset of stocks over which options were traded. Panel A reports statistics for the full sample of funds, Panel B
reports statistics for funds that use derivatives, and Panel C reports statistics for funds that do not use derivatives.
Panel A - All Funds

Stocks (All) Stocks (Sub) Futures Call Options Put Options
N % N % N % N % N %
Mean contracts net 74.93 90.2459% 24.25 54.3645% 0.19 0.1243% 0.07 -0.0017% 0.02 -0.0001%
Mean contracts long 73.98 90.2521% 23.77 54.3706% 0.17 0.1131% 0.04 0.0003% 0.01 0.0001%
Mean contracts short 0.95 -0.0061% 0.48 -0.0061% 0.02 -0.0112% 0.03 -0.0020% 0.00 -0.0002%
Mean net delta exposure 74.93 90.2459% 24.25 54.3645% 0.19 3.1345% 0.07 0.0165% 0.02 0.0001%
Mean long delta exposure 73.98 90.2521% 23.77 54.3706% 0.17 2.8525% 0.04 0.0278% 0.01 -0.0012%
Mean short delta exposure 0.95 -0.0061% 0.48 -0.0061% 0.02 -0.2820% 0.03 -0.0113% 0.00 0.0013%
Mean Fund Size $346,065,932
Number of Funds 34
Panel B - Users of Derivatives

N % N % N % N % N %
Mean net contract value 94.40 86.2450% 32.16 62.9843% 0.39 0.2487% 0.14 -0.0034% 0.04 -0.0001%
Mean long contract value 94.40 86.2518% 32.16 62.9912% 0.35 0.2262% 0.08 0.0006% 0.03 0.0002%
Mean short contract value 0.00 -0.0068% 0.00 -0.0068% 0.04 -0.0224% 0.06 -0.0040% 0.01 -0.0003%
Mean net delta exposure 94.40 86.2450% 32.16 62.9843% 0.39 6.2689% 0.14 0.0329% 0.04 0.0002%
Mean long delta exposure 94.40 86.2518% 32.16 62.9912% 0.35 5.7050% 0.08 0.0556% 0.03 -0.0025%
Mean short delta exposure 0.00 -0.0068% 0.00 -0.0068% 0.04 -0.5639% 0.06 -0.0226% 0.01 0.0026%
Number of Funds 17
Panel C - Non-Users of Derivatives

N % N % N % N % N %
Mean net contract value 55.45 94.2469% 16.33 45.7446% - - - - - -
Mean long contract value 53.55 94.2523% 15.39 45.7500% - - - - - -
Mean short contract value 1.90 -0.0054% 0.95 -0.0054% - - - - - -
Mean net delta exposure 55.45 94.2469% 16.33 45.7446% - - - - - -
Mean long delta exposure 53.55 94.2523% 15.39 45.7500% - - - - - -
Mean short delta exposure 1.90 -0.0054% 0.95 -0.0054% - - - - - -
Number of Funds 17
35
Table II
Descriptive Statistics of Fund Trades
This table provides descriptive statistics of the daily trades sourced from the Portfolio Analytics Database
for the period 1 January 1995 to 31 December 2002. For stocks and options, trade value refers to the
number of securities traded x the price per security. For futures, trade value refers to the number of
contracts trade x the SPI futures value x $25. Degree of moneyness is measured as the spot price of the
underlying asset minus the strike price of the option, divided by the spot price of the underlying asset.
Panel A - Stocks
Mean Std. Dev. Median
Average trade value ($) 564,667 2,405,018 185,429
Number of trades per month 117 125 81
Proportion of buy trades 57.01% 20.74% 55.56%
Panel B - Futures
Average trade value ($) 757,198 3,721,481 39,720
Time to maturity (Days) 35.63 23.74 33.42
Panel C - Call Options

Average trade value ($) 85,648 188,579 26,200
Degree of moneyness 3.95% 18.62% -1.20%
Panel D - Put Options

Average trade value ($) 29,694 42,989 17,834
Degree of moneyness 2.92% 8.58% 2.97%
36
Table III
Location of Distributional Moments and Risk Measures
This table reports the mean of distributional moments and risk measures of fund returns. Panel A reports the mean, standard
deviation, skewness, and kurtosis for the full sample of funds, then separated by derivative users and non-users. Panel B reports the
alpha, beta, idiosyncratic risk, timing beta, and downside risk of fund returns. Tests of Differences tests the null hypothesis that the
mean estimates are equal for nonusers and users of derivatives. The t test is a parametric test, whilst the Wilcoxon rank sum test is a
Panel A - Moments of the Distribution of Returns

Aggregate Nonusers Users Tests of Differences
Fund Style N Mean N Mean N Mean t-test (p -value) Wilcoxon (p -value)
Mean All Funds 34 0.0108 17 0.0107 17 0.0108 -0.05 (0.9643) 0.57 (0.5698)
Growth 5 0.0095 2 0.0075 3 0.0109 -0.83 (0.5571) -0.58 (0.5637)
GARP 9 0.0068 4 0.0036 5 0.0092 -0.89 (0.4294) -0.25 (0.8065)
Value 11 0.0135 8 0.0142 3 0.0117 0.82 (0.4438) 0.82 (0.4142)
Neutral 6 0.0129 3 0.0131 3 0.0127 0.16 (0.8833) -0.22 (0.8273)
Other 3 0.0105 - - 3 0.0105 - - - -
Standard All Funds 34 0.0386 17 0.0401 17 0.0370 1.16 (0.2601) -0.16 (0.8768)
Deviation Growth 5 0.0436 2 0.0516 3 0.0383 1.15 (0.4511) 1.16 (0.2482)
GARP 9 0.0409 4 0.0433 5 0.0391 0.57 (0.602) -0.49 (0.6242)
Value 11 0.0364 8 0.0374 3 0.0336 1.39 (0.2081) 1.23 (0.2207)
Neutral 6 0.0361 3 0.0354 3 0.0367 -0.47 (0.6795) -0.66 (0.5127)
Other 3 0.0361 - - 3 0.0361 - - - -
Skewness All Funds 34 -0.3251 17 -0.3756 17 -0.2747 -0.78 (0.4438) -0.64 (0.524)
Growth 5 -0.6265 2 -0.8558 3 -0.4736 -0.72 (0.5917) 0.00 (1)
GARP 9 -0.1104 4 -0.1604 5 -0.0704 -0.29 (0.786) 0.25 (0.8065)
Value 11 -0.3931 8 -0.4736 3 -0.1785 -2.50 (0.0415) ** -1.63 (0.1025)
Neutral 6 -0.1436 3 -0.0808 3 -0.2064 0.42 (0.7106) 0.66 (0.5127)
Other 3 -0.5807 - - 3 -0.5807 - - - -
Kurtosis All Funds 34 0.4339 17 0.5059 17 0.3619 0.55 (0.5899) 0.91 (0.3614)
Growth 5 0.6853 2 0.8092 3 0.6028 0.21 (0.8657) 0.00 (1)
GARP 9 0.4235 4 0.6088 5 0.2752 0.36 (0.7428) 1.23 (0.2207)
Value 11 0.3754 8 0.5244 3 -0.0219 2.21 (0.0598) 1.43 (0.153)
Neutral 6 0.2267 3 0.1170 3 0.3365 -0.49 (0.6577) -0.22 (0.8273)
Other 3 0.6747 - - 3 0.6747 - - - -
Panel B - Risk Measures

Aggregate Nonusers Users Tests of Differences
Fund Style N Mean N Mean N Mean t-test (p -value) Wilcoxon (p -value)
Alpha All Funds 34 0.0022 17 0.0020 17 0.0024 -0.28 (0.7822) 0.02 (0.9863)
Growth 5 0.0015 2 -0.0006 3 0.0029 -2.00 (0.2539) -1.73 (0.0833) *
GARP 9 -0.0005 4 -0.0030 5 0.0015 -1.12 (0.3261) -1.72 (0.0864) *
Value 11 0.0047 8 0.0048 3 0.0044 0.12 (0.9116) 0.82 (0.4142)
Neutral 6 0.0027 3 0.0030 3 0.0024 0.46 (0.6684) 0.66 (0.5127)
Other 3 0.0015 - - 3 0.0015 - - - -
Beta All Funds 34 0.9208 17 0.9044 17 0.9371 -0.85 (0.3991) -1.05 (0.2935)
Growth 5 0.9181 2 0.8695 3 0.9505 -0.53 (0.68) -0.58 (0.5637)
GARP 9 0.9444 4 0.9594 5 0.9324 0.31 (0.7709) 0.00 (1)
Value 11 0.8607 8 0.8620 3 0.8573 0.05 (0.9621) -0.41 (0.6831)
Neutral 6 0.9698 3 0.9676 3 0.9721 -0.13 (0.9053) -0.22 (0.8273)
Other 3 0.9762 - - 3 0.9762 - - - -
Idiosyncratic All Funds 34 0.0159 17 0.0179 17 0.0139 1.05 (0.3019) 0.91 (0.3614)
risk Growth 5 0.0226 2 0.0349 3 0.0144 0.78 (0.5773) 0.00 (1)
GARP 9 0.0184 4 0.0185 5 0.0184 0.01 (0.9953) -0.25 (0.8065)
Value 11 0.0157 8 0.0167 3 0.0131 0.72 (0.5249) 1.02 (0.3074)
Neutral 6 0.0103 3 0.0091 3 0.0115 -1.07 (0.3874) -0.66 (0.5127)
Other 3 0.0090 - - 3 0.0090 - - - -
Timing All Funds 34 -0.0505 17 -0.0519 17 -0.0491 -0.02 (0.9828) -0.33 (0.7435)
beta Growth 5 -0.2037 2 -0.4359 3 -0.0488 -0.87 (0.5433) 0.00 (1)
GARP 9 0.1624 4 0.3814 5 -0.0128 0.91 (0.4244) 0.49 (0.6242)
Value 11 -0.1486 8 -0.1835 3 -0.0558 -1.53 (0.1616) -0.82 (0.4142)
Neutral 6 0.0162 3 -0.0229 3 0.0553 -1.76 (0.1562) -1.53 (0.1266)
Other 3 -0.2077 - - 3 -0.2077 - - - -
Downside All Funds 34 0.0108 17 0.0126 17 0.0090 1.19 (0.2439) 1.40 (0.163)
risk Growth 5 0.0149 2 0.0241 3 0.0088 0.81 (0.5659) 0.00 (1)
GARP 9 0.0141 4 0.0153 5 0.0131 0.28 (0.7873) 0.00 (1)
Value 11 0.0100 8 0.0108 3 0.0080 0.79 (0.489) 1.02 (0.3074)
Neutral 6 0.0063 3 0.0060 3 0.0067 -0.34 (0.7543) -0.22 (0.8273)
Other 3 0.0057 - - 3 0.0057 - - - -
37
Table IV
Dispersion of Distributional Moments and Risk Measures
This table reports the standard deviation of distributional moments and risk measures of fund returns. Panel A reports the
mean, standard deviation, skewness, and kurtosis for the full sample of funds, then separated by derivative users and non-
users. Panel B reports the alpha, beta, idiosyncratic risk, timing beta, and downside risk of fund returns. F-Test is a
comparison of variance of the parameters between nonusers and users of derivatives. Results for each parameter are also
Panel A - Moments of the Distribution of Returns

Aggregate Nonusers Users
Fund Style N Std. Dev. N Std. Dev. N Std. Dev. F-Test (p -value)
Mean All Funds 34 0.0060 17 0.0081 17 0.0029 7.72 (0.0002) ***
Growth 5 0.0035 2 0.0059 3 0.0008 58.07 (0.1092)
GARP 9 0.0085 4 0.0120 5 0.0043 7.84 (0.0988) *
Value 11 0.0053 8 0.0058 3 0.0038 2.28 (0.5119)
Neutral 6 0.0026 3 0.0036 3 0.0018 3.86 (0.4116)
Other 3 0.0007 - - 3 0.0007 - -
Standard All Funds 34 0.0078 17 0.0104 17 0.0033 10.33 (0) ***
Deviation Growth 5 0.0110 2 0.0162 3 0.0023 49.78 (0.1192)
GARP 9 0.0096 4 0.0142 5 0.0049 8.55 (0.0871) *
Value 11 0.0066 8 0.0077 3 0.0001 9073.40 (0.0001) ***
Neutral 6 0.0029 3 0.0044 3 0.0008 29.61 (0.0653) *
Other 3 0.0001 - - 3 0.0001 - -
Skewness All Funds 34 0.3757 17 0.4650 17 0.2637 3.11 (0.0294) **
Growth 5 0.4435 2 0.7283 3 0.2013 13.09 (0.2604)
GARP 9 0.3931 4 0.5841 5 0.2208 7.00 (0.1163)
Value 11 0.2555 8 0.2463 3 0.1377 3.20 (0.3617)
Neutral 6 0.3355 3 0.4981 3 0.1463 11.59 (0.1588)
Other 3 0.2303 - - 3 0.2303 - -
Kurtosis All Funds 34 0.7598 17 0.9816 17 0.4648 4.46 (0.0047) ***
Growth 5 0.6986 2 1.3618 3 0.1527 79.59 (0.0913) *
GARP 9 1.1822 4 1.8175 5 0.5056 12.92 (0.0469) **
Value 11 0.5335 8 0.5410 3 0.2711 3.98 (0.2855)
Neutral 6 0.5075 3 0.6788 3 0.3833 3.14 (0.4836)
Other 3 0.7062 - - 3 0.7062 - -
Panel B - Risk Measures

Aggregate Nonusers Users
Fund Style N Std. Dev. N Std. Dev. N Std. Dev. F-Test (p -value)
Alpha All Funds 34 0.0044 17 0.0058 17 0.0026 5.06 (0.0024) ***
Growth 5 0.0023 2 0.0023 3 0.0010 5.39 (0.4374)
GARP 9 0.0057 4 0.0075 5 0.0033 5.11 (0.1803)
Value 11 0.0045 8 0.0050 3 0.0038 1.72 (0.6635)
Neutral 6 0.0015 3 0.0015 3 0.0017 0.71 (0.8282)
Other 3 0.0015 - - 3 0.0015 - -
Beta All Funds 34 0.1109 17 0.1086 17 0.1141 0.91 (0.8445)
Growth 5 0.1226 2 0.2083 3 0.0665 9.81 (0.3088)
GARP 9 0.1355 4 0.0750 5 0.1791 0.18 (0.1554)
Value 11 0.1109 8 0.1091 3 0.1406 0.60 (0.6835)
Neutral 6 0.0391 3 0.0451 3 0.0420 1.15 (0.9287)
Other 3 0.0106 - - 3 0.0106 - -
Idiosyncratic All Funds 34 0.0112 17 0.0137 17 0.0078 3.12 (0.029) **
risk Growth 5 0.0218 2 0.0371 3 0.0028 173.85 (0.0593) *
GARP 9 0.0120 4 0.0136 5 0.0121 1.26 (0.8449)
Value 11 0.0064 8 0.0061 3 0.0078 0.61 (0.6855)
Neutral 6 0.0027 3 0.0008 3 0.0037 0.04 (0.0831) *
Other 3 0.0028 - - 3 0.0028 - -
Timing All Funds 34 0.3676 17 0.5036 17 0.1584 10.10 (0) ***
beta Growth 5 0.3795 2 0.6278 3 0.0320 384.19 (0.0386) **
GARP 9 0.5784 4 0.8453 5 0.2165 15.24 (0.0365) **
Value 11 0.1925 8 0.2165 3 0.0580 13.95 (0.0721) *
Neutral 6 0.0648 3 0.0483 3 0.0599 0.65 (0.7879)
Other 3 0.2040 - - 3 0.2040 - -
Downside All Funds 34 0.0088 17 0.0106 17 0.0063 2.83 (0.0451) **
risk Growth 5 0.0158 2 0.0267 3 0.0014 385.53 (0.0386) **
GARP 9 0.0108 4 0.0129 5 0.0102 1.59 (0.6929)
Value 11 0.0046 8 0.0043 3 0.0055 0.62 (0.6972)
Neutral 6 0.0023 3 0.0023 3 0.0027 0.73 (0.8427)
Other 3 0.0017 - - 3 0.0017 - -
38
Table V
Momentum by Proportion of Trades
This table reports descriptive statistics on the proportions of investment manager trades in options over stocks
exhibiting momentum and non-momentum behaviour. Chi-squared is a goodness-of-fit test on the number of option
trades in the Loser, Non-momentum, and Winner categories. In Panel A, loser and winner stock portfolios are defined
as the lower and upper deciles based on past 12 month buy-and-hold returns. The expected proportions of loser, non-
momentum, and winner trades are 10%, 80% and 10% respectively. In Panel B, loser and winner stock portfolios are
defined as the lower and upper quintiles based on past 12 month buy-and-hold returns. The expected proportion of
loser, non-momentum, and winner trades are 20%, 60%, and 20% respectively. Tests are performed by fund.
Panel A - Momentum on Upper and Lower Deciles by Performance

% Non-
No. of Trades % Loser Momentum % Winner Chi-squared p-value
Call Option Buy Trades
Mean 520.90 1.32% 90.30% 8.37% 56.01 0.0187
Median 275.00 0.93% 90.45% 7.18% 32.32 0.0000
Min 56.00 0.00% 79.75% 0.00% 4.36 0.0000
Max 2950.00 5.04% 100.00% 18.40% 297.97 0.1132
No. significant @ 10% 9
Total funds in sample 10
Call Option Sell Trades
Mean 563.67 0.69% 91.25% 8.06% 62.23 0.0047
Median 247.00 0.72% 90.63% 8.97% 35.98 0.0000
Min 78.00 0.00% 84.78% 2.58% 6.94 0.0000
Max 3044.00 1.28% 97.13% 14.13% 294.38 0.0312
Put Option Buy Trades
Mean 296.83 1.40% 92.47% 6.13% 39.22 0.0073
Median 193.00 1.51% 92.52% 5.70% 14.82 0.0065
Min 56.00 0.00% 88.50% 3.91% 8.31 0.0000
Max 972.00 3.30% 95.78% 9.73% 157.61 0.0157
Put Option Sell Trades
Mean 321.33 0.29% 93.73% 5.98% 42.47 0.0048
Median 166.50 0.22% 93.78% 5.82% 22.60 0.0004
Min 59.00 0.00% 90.28% 3.02% 8.16 0.0000
Max 1218.00 0.81% 96.55% 9.72% 151.99 0.0169
Delta Increasing Trades
Mean 716.00 1.06% 90.75% 8.19% 79.41 0.01
Median 361.50 0.75% 91.07% 6.88% 44.05 0.00
Min 59.00 0.00% 81.56% 0.00% 5.77 0.00
Max 4168.00 3.37% 100.00% 16.76% 432.54 0.06
Delta Decreasing Trades
Mean 693.90 1.00% 91.39% 7.61% 76.30 0.01
Median 382.00 0.86% 91.53% 7.48% 47.19 0.00
Min 50.00 0.33% 88.51% 4.33% 4.90 0.00
Max 4016.00 2.00% 95.02% 10.81% 420.10 0.09
39
Panel B - Momentum on Upper and Lower Quintiles by Performance
% Non-
No. of Trades % Loser Momentum % Winner Chi-squared p-value
Mean 358.87 5.81% 64.72% 29.47% 69.49 0.07
Median 119.00 3.68% 66.96% 30.80% 26.72 0.00
Min 25.00 0.00% 47.37% 10.00% 0.08 0.00
Max 2950.00 18.75% 80.00% 50.00% 532.89 0.96
Mean 431.67 6.18% 63.35% 30.47% 78.51 0.01
Median 200.00 2.56% 65.04% 31.67% 28.77 0.00
Min 26.00 1.09% 38.46% 17.39% 5.03 0.00
Max 3044.00 30.77% 76.09% 45.71% 512.22 0.08
Mean 260.00 7.89% 74.18% 17.92% 37.54 0.06
Median 113.00 4.53% 74.39% 19.86% 15.16 0.00
Min 39.00 0.00% 61.95% 7.69% 1.97 0.00
Max 972.00 23.01% 92.31% 26.92% 155.88 0.37
Mean 321.33 5.43% 73.47% 21.10% 53.98 0.02
Median 166.50 3.11% 73.24% 21.38% 22.44 0.00
Min 59.00 1.69% 69.31% 13.86% 3.87 0.00
Max 1218.00 16.83% 79.31% 27.78% 209.21 0.14
Mean 490.73 5.42% 64.51% 30.07% 91.06 0.07
Median 178.00 3.51% 67.57% 26.89% 29.40 0.00
Min 27.00 0.00% 44.90% 14.05% 0.18 0.00
Max 4168.00 18.18% 78.57% 52.54% 730.92 0.91
Mean 506.29 6.32% 65.47% 28.21% 83.60 0.02
Median 170.50 3.35% 67.53% 27.58% 29.17 0.00
Min 27.00 0.00% 40.74% 7.69% 4.17 0.00
Max 4016.00 29.63% 92.31% 51.11% 634.09 0.12
40
Table VI
Momentum by Value-weighted Proportion of Trades
This table reports descriptive statistics on the value-weighted proportions of investment manager trades in options over
stocks exhibiting momentum and non-momentum behaviour. The number of trades are weighted by the value of
equivalent ordinary share exposure of the trade. Chi-squared is a goodness-of-fit test on the value-weighted number of
option trades in the Loser, Non-momentum, and Winner categories. In Panel A, loser and winner stock portfolios are
defined as the lower and upper deciles based on past 12 month buy-and-hold returns. The expected proportions of loser,
non-momentum, and winner trades are 10%, 80% and 10% respectively. In Panel B, loser and winner stock portfolios
are defined as the lower and upper quintiles based on past 12 month buy-and-hold returns. The expected proportion of
loser, non-momentum, and winner trades are 20%, 60%, and 20% respectively. Tests are performed by fund.
Panel A - Momentum on Upper and Lower Deciles by Performance

Total Value-
Weighted
Number of % Non-
Trades % Loser Momentum % Winner Chi-squared p-value
Mean 520.90 0.99% 90.60% 8.41% 63.94 0.00
Median 275.00 0.26% 93.36% 5.81% 31.25 0.00
Min 56.00 0.00% 75.79% 0.00% 8.39 0.00
Max 2950.00 5.26% 100.00% 18.96% 295.88 0.02
Mean 563.67 0.66% 92.18% 7.16% 69.42 0.00
Median 247.00 0.34% 92.97% 6.62% 35.22 0.00
Min 78.00 0.00% 83.15% 1.91% 9.00 0.00
Max 3044.00 3.04% 98.05% 13.81% 304.92 0.01
Mean 296.83 0.68% 96.67% 2.66% 57.92 0.00
Median 193.00 0.14% 96.64% 2.31% 33.87 0.00
Min 56.00 0.02% 95.46% 1.65% 20.12 0.00
Max 972.00 2.41% 97.94% 4.36% 143.84 0.00
Mean 321.33 0.20% 95.72% 4.08% 54.69 0.00
Median 166.50 0.24% 95.87% 3.90% 34.45 0.00
Min 59.00 0.00% 92.20% 1.02% 11.36 0.00
Max 1218.00 0.54% 98.98% 7.80% 177.55 0.00
Mean 716.00 0.86% 91.47% 7.67% 90.18 0.00
Median 361.50 0.25% 93.78% 5.73% 53.54 0.00
Min 59.00 0.00% 78.45% 0.00% 6.67 0.00
Max 4168.00 4.68% 100.00% 16.87% 421.93 0.04
Mean 693.90 0.67% 92.74% 6.59% 94.69 0.00
Median 382.00 0.28% 93.47% 6.28% 67.34 0.00
Min 50.00 0.03% 83.76% 1.93% 8.98 0.00
Max 4016.00 2.89% 98.04% 13.35% 413.03 0.01
41
Panel B - Momentum on Upper and Lower Quintiles by Performance
Total Value-
Weighted
Number of % Non-
Trades % Loser Momentum % Winner Chi-squared p-value
Mean 358.87 3.84% 60.59% 35.57% 104.40 0.00
Median 119.00 2.94% 62.14% 33.90% 26.43 0.00
Min 25.00 0.00% 39.16% 8.80% 8.71 0.00
Max 2950.00 10.49% 86.97% 58.43% 519.97 0.01
Mean 431.67 3.40% 61.14% 35.46% 102.67 0.00
Median 200.00 3.27% 66.08% 32.57% 57.63 0.00
Min 26.00 0.00% 20.14% 10.20% 7.73 0.00
Max 3044.00 10.35% 85.72% 79.86% 541.64 0.02
Mean 260.00 6.57% 78.77% 14.65% 48.32 0.01
Median 113.00 3.06% 78.07% 16.56% 18.85 0.00
Min 39.00 0.00% 69.61% 4.08% 6.17 0.00
Max 972.00 24.47% 95.92% 25.01% 177.48 0.05
Mean 321.33 6.55% 73.64% 19.81% 62.69 0.18
Median 166.50 3.18% 76.96% 19.86% 32.84 0.00
Min 59.00 2.56% 60.78% 12.88% 0.17 0.00
Max 1218.00 18.37% 84.04% 28.06% 222.63 0.92
Mean 490.73 0.87% 84.36% 14.77% 131.92 0.00
Median 178.00 0.22% 89.47% 10.31% 39.81 0.00
Min 27.00 0.00% 42.26% 0.00% 8.41 0.00
Max 4168.00 4.68% 100.00% 55.05% 719.51 0.01
Mean 506.29 0.56% 88.27% 11.16% 114.77 0.00
Median 170.50 0.21% 93.47% 6.28% 54.11 0.00
Min 27.00 0.00% 41.32% 0.00% 8.43 0.00
Max 4016.00 2.89% 100.00% 58.68% 671.38 0.01
42
Table VII
Event Study of Informed Trading
This table reports the mean and percentiles of the t -statistics of the cumulative abnormal returns for underlying stocks in event
windows around investment manager option trades. For cumulative abnormal returns, the numbers in the brackets represent
the period of the event window. The first number in the brackets is the day in which the event window begins, and the second
number is the day in which the event window ends. These days are relative to an option trade event, set at day 0.
Panel A - Call Option Buy Trades

Percentile
Mean 1st 10th 25th 50th 75th 90th 99th
CAR [-10, -1] 0.14 -2.15 ** -1.01 -0.40 0.12 0.72 1.33 2.42 **
CAR [-5, -1] 0.10 -2.25 ** -1.05 -0.51 0.04 0.73 1.38 2.77 ***
CAR [-3, -1] 0.07 -2.42 ** -1.10 -0.51 0.03 0.67 1.37 3.03 ***
CAR [-1, -1] 0.03 -2.34 ** -1.05 -0.53 0.00 0.62 1.24 2.93 ***
CAR [0, 0] -0.11 -2.78 *** -1.31 -0.70 -0.08 0.55 1.27 2.79 ***
CAR [0, 2] -0.06 -2.69 *** -1.29 -0.65 -0.06 0.61 1.26 2.70 ***
CAR [0, 4] -0.05 -2.57 *** -1.14 -0.60 -0.02 0.54 1.22 2.63 ***
CAR [0, 9] -0.02 -2.41 ** -1.09 -0.54 0.00 0.58 1.12 2.40 **
Panel B - Call Option Sell Trades

Percentile
CAR [-10, -1] 0.12 -2.67 *** -1.04 -0.43 0.15 0.75 1.36 2.50 **
CAR [-5, -1] 0.10 -2.58 *** -1.08 -0.51 0.06 0.73 1.42 2.69 ***
CAR [-3, -1] 0.11 -2.64 *** -1.10 -0.51 0.07 0.75 1.43 2.98 ***
CAR [-1, -1] 0.09 -2.95 *** -1.10 -0.49 0.06 0.69 1.33 2.88 ***
CAR [0, 0] 0.19 -2.91 *** -1.16 -0.51 0.16 0.85 1.56 3.42 ***
CAR [0, 2] 0.07 -2.51 ** -1.20 -0.58 0.06 0.71 1.36 2.88 ***
CAR [0, 4] 0.09 -2.34 ** -1.02 -0.50 0.06 0.66 1.28 2.45 **
CAR [0, 9] 0.05 -2.39 ** -1.08 -0.48 0.04 0.61 1.23 2.57 ***
Panel C - Put Option Buy Trades

Percentile
CAR [-10, -1] 0.00 -2.62 *** -1.22 -0.53 0.05 0.59 1.18 2.21 **
CAR [-5, -1] -0.02 -3.20 *** -1.18 -0.59 0.03 0.57 1.16 2.37 **
CAR [-3, -1] -0.04 -3.14 *** -1.26 -0.60 -0.02 0.61 1.19 2.57 ***
CAR [-1, -1] 0.00 -3.41 *** -1.18 -0.52 0.02 0.57 1.23 2.76 **
CAR [0, 0] 0.19 -3.47 *** -1.05 -0.36 0.27 0.90 1.54 3.25 ***
CAR [0, 2] 0.18 -2.92 *** -1.01 -0.40 0.17 0.83 1.47 2.83 ***
CAR [0, 4] 0.10 -2.63 *** -0.94 -0.41 0.13 0.80 1.44 2.74 ***
CAR [0, 9] 0.06 -2.51 ** -1.06 -0.43 0.10 0.71 1.25 2.52 **
Panel D - Put Option Sell Trades

Percentile
CAR [-10, -1] -0.10 -2.85 *** -1.31 -0.66 -0.06 0.47 1.10 2.32 **
CAR [-5, -1] -0.11 -2.89 *** -1.25 -0.68 -0.10 0.47 1.06 2.43 **
CAR [-3, -1] -0.08 -3.01 *** -1.33 -0.66 -0.09 0.55 1.20 2.77 ***
CAR [-1, -1] -0.09 -3.52 *** -1.14 -0.63 -0.09 0.45 1.09 2.58 ***
CAR [0, 0] -0.12 -3.37 *** -1.39 -0.75 -0.19 0.54 1.24 3.19 ***
CAR [0, 2] -0.02 -2.92 *** -1.22 -0.62 -0.02 0.56 1.16 3.55 ***
CAR [0, 4] -0.01 -2.63 *** -1.16 -0.57 -0.02 0.50 1.22 2.86 ***
CAR [0, 9] 0.01 -2.61 *** -1.14 -0.51 0.01 0.59 1.15 2.60 ***
Panel E - Delta Increasing Trades

Percentile
CAR [-10, -1] 0.06 -2.40 ** -1.13 -0.48 0.06 0.65 1.27 2.40 **
CAR [-5, -1] 0.03 -2.48 ** -1.12 -0.57 0.00 0.63 1.28 2.68 ***
CAR [-3, -1] 0.03 -2.69 *** -1.14 -0.55 -0.01 0.62 1.32 2.95 ***
CAR [-1, -1] -0.01 -2.63 *** -1.08 -0.56 -0.04 0.58 1.20 2.83 ***
CAR [0, 0] -0.11 -2.84 *** -1.33 -0.72 -0.11 0.55 1.26 2.82 ***
CAR [0, 2] -0.05 -2.74 *** -1.27 -0.64 -0.05 0.59 1.21 2.80 ***
CAR [0, 4] -0.03 -2.61 *** -1.15 -0.59 -0.02 0.53 1.22 2.67 ***
CAR [0, 9] -0.01 -2.51 ** -1.11 -0.53 0.00 0.58 1.13 2.47 **
43
APPENDIX – CALCULATION OF EQUIVALENT ORDINARY SHARE
EXPOSURES
Since derivative exposures contain leverage, the cost of the option does not
represent the level of exposure to changes in the underlying stock price. Thus,
measuring the level of exposure by the market price of the derivative securities will
significantly underestimate the true level of exposure to the underlying stock. Due to
the availability of data from accounting disclosures, research into corporate derivative
use has typically measured the level of exposure by the notional principal of the
contracts (see Geczy, Minton and Schrand (1997), Hentschel and Kothari (2001)).
Whilst this measure incorporates the leverage of derivative securities, it does not
capture the price sensitivity relative to the underlying asset, and is therefore an
incomplete proxy for the level of derivative exposure.
Pinnuck (2004) suggests a measurement of the price sensitivity of an options
exposure by evaluating the holdings on an “ordinary share equivalent” basis. This
involves replacing the value of options exposures with the equivalent holding of
ordinary shares which would yield the same level of share price exposure. In this
paper, a similar approach is taken and expanded across both options and futures
holdings.
The equivalent ordinary share exposure is the value of a position in the
underlying stock that would result in the same change in value following a price
change in the underlying stock. For derivatives, this price sensitivity is measured by
delta, the rate of change of the derivative price with respect to a change in the
underlying asset price. Generally, delta is defined as:
∂D
∆=
∂P
where ∆ = delta of the derivative
44
∂D = an instantaneous change in the price of the derivative
∂P = an instantaneous change in the price of the underlying asset
Futures contracts
Since futures contracts are marked-to-market on a daily basis, a change in the
price of the underlying asset results in an immediate gain to the futures holder.
Consequently, Hull (2003) shows that the delta of a futures is equal to:
∆ FUTURE = e (r − q )T
where r = risk free rate of return
q = yield on the underlying asset
T = Time to maturity
The funds in this sample confine their trading in futures to Share Price Index (SPI)
futures, and do not trade futures over individual shares. Thus, the delta of these
futures contracts is e rT , since the SPI does not pay a yield. The equivalent ordinary
share exposure of a futures holding is equal to:
No. of futures contracts × Futures Price × $25 × ∆ FUTURE 22
Option contracts
The delta of a European option on a non-dividend paying stock can be found
from the Black-Scholes option pricing model.
For a European call option on a non-dividend paying stock:
∆ CALL = N (d1 )
For a European put option on a non-dividend paying stock:
∆ PUT = N (d1 ) − 1
22
Share Price Index futures on the Sydney Futures Exchange (SFE) are priced at $25 per point. The
futures price is quoted as an index value.
45
ln (S 0 / K ) + (r + σ 2 / 2)T
where d 1 =
σ T
S0 = Spot price of the stock
K = Strike price of the option
r = risk free rate of return
σ = volatility of the underlying stock
T = Time to maturity
N (x ) = the value of the cumulative standard normal distribution at x
The options listed on the Australian Stock Exchange Derivatives (ASXD)
market are American style exercise. Furthermore, stocks on the ASX typically pay
relatively high dividend yields.23 As a result, the Black-Scholes solutions for delta
may no longer be applied. Whilst methods have been found to adjust the Black-
Scholes model for early exercise (Black (1975)), no closed form solution can be found
for pricing American put options. These options can be valued using numerical
procedures. In this paper, we employ a 50-step binomial option pricing model from
Cox, Ross and Rubenstein (1979). The value of the ith node of the tree is adjusted for
dividends using a process outlined by Hull (2003):
S 0*u j d i − j + De − r (τ −iδt ) , j = 0, 1, …, i
when iδt < τ ; and
S 0*u j d i − j , j = 0, 1, …, i
when iδt > τ .
where S * = S − De − r (τ −iδt ) , when iδt ≤ τ
S * = S , when iδt > τ
23
In a study of gross dividends per share across major stocks markets around the world, Australia
ranked ninth with an average dividend yield of 3.4% per annum. In comparison, the United States
ranked 40th, with an average dividend yield of 1.4%. Source: Wren Research, August 2002.
46
D = the dollar amount of the dividend
τ = the ex-dividend date of the stock
u = eσ δt
d = 1
u
In this model, both the timing and amount of dividends are assumed to be
known with perfect foresight. Furthermore, the volatility of the underlying stock is
approximated by annualising the standard deviation of the daily stock returns for the
past 30 trading days.24 Finally, delta is calculated from this model as:
Pu ,1 − Pd ,1
∆ OPTION =
S 0*u − S 0* d
where Pu ,1 = Value of the option on the “up” change of the first node
Pu ,1 = Value of the option on the “down” change of the first node
The equivalent ordinary share exposure of an options position is then
calculated as:
No. of options contracts × No. of shares per contract × Underlying stock price × ∆ OPTION 25
Several issues must be noted regarding the appropriateness of using delta in
transforming options exposures into equivalent ordinary share exposures. Firstly,
delta measures the price sensitivity of the option price at the current spot stock price.
The value of delta will change over time, and with changes in the spot stock price.
24
It should be noted that the correct measure of volatility used to value options is expected volatility.
The market consensus of expected volatility is observable through calculating implied volatility.
However, this measure is only observable at the precise time in which a trade occurs, and only applies
at the current stock price. Since options are thinly traded securities, and we require valuation as at each
month-end in the sample period, implied volatility is unable to be computed. The implied volatilities
computed as at each month-end were suffer significant misspecification due to stale option prices.
Hence, we utilise a measure of historical volatility.
25
Exchange-traded options on the ASXD are written over 1000 shares, however this is adjusted in the
event of a capital distribution.
47
Secondly, delta is an instantaneous measure of price sensitivity. The level of exposure
computed by delta will only apply to small changes in the stock price.
48

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The Use of Derivatives by Investment

Managers and Implications for Portfolio

School of Banking and Finance, The University of New South Wales,

This study provides an empirical examination of derivative instruments used by

JEL classification: G11, G23

Keywords: Derivatives, Managed Funds, Investment Performance, Portfolio Risk

* Corresponding author. Email: aaron.ng@unsw.edu.au 1

This study provides an empirical examination of derivative instruments used by

JEL classification: G11, G23

Keywords: Derivatives, Managed Funds, Investment Performance, Portfolio Risk

environment in which investors are continuously exposed to a broad range of dynamic

of institutions. As a product of developments arising from the literature, derivative

range of alternatives in managing their financial market exposures.

Such examples include Long–Term Capital Management (LTCM) in the U.S.,

have attracted the close attention of risk management executives, investors,

governments and market regulators, as well as the media.

In attempting to prevent corporate failure resulting from the use of derivatives,

regulators have generally approached the matter from a disclosure perspective.3

management policies, and constraints on the use of derivatives.4 The Australian

Theoretical literature proposes that derivatives provide users with efficiency

institutional investors might use derivative instruments. If derivatives provide no

questions as to why market participants continue to engage in large volumes of

The primary contribution of this study is to better understand how derivatives

has largely focussed on corporate hedging, which is likely to display considerable

conclude that derivatives do not lead to significant differences in performance or risk.

the trading strategies executed by managers in derivative securities.

This study benefits significantly from a unique and confidential dataset of

typically analysed the portfolio holdings of investment managers observed at quarter-

such as derivatives (Moskowitz (2000)).7 To evaluate the use of derivatives, Koski

derivative use in considerably finer detail.

Consistent with the literature, we document few observable differences in either

We next examine the propensity for active equity managers to transact in

options on stocks exhibiting momentum by analysing the proportion of option trades

trading in options markets.

Contrary to public perception that derivatives are inherently risky financial

by institutional traders does not lead to significant differences in the performance or

risk between derivative users and non-users.

paper. Section 3 outlines the empirical methodologies employed in testing the

findings. The final section concludes.

Derivatives provide potential benefits through reduced transaction costs, both

leveraged exposure to market risks, which may be exploited by investment managers

in response to agency incentives.8 However, little empirical evidence exists to verify

H1: The use of derivatives causes significant impacts on the performance

and risk of Australian investment managers.

Since the payoffs of equity derivatives are determined by the performance of

engage in momentum strategies in their equity stock holdings.9

Several factors in the Australian institutional environment make derivatives

potentially more appropriate than shares in implementing momentum strategies. The

restricting fund borrowings prevents a manager’s ability to short-sell downside

momentum stocks, or purchase upside momentum stocks where a fund is at full

exhibiting downside momentum. In each of these circumstances, derivatives may be

used to gain exposure to expected price momentum, overcoming constraints in

underlying stock markets.

H2: Active investment managers are using options markets to implement

momentum-based trading strategies.

in option markets at an aggregate market level;12 however, there is no evidence to

support informed trading in options at an individual stock level.

Option contracts provide leverage and inherent insurance, which will be

exposure to an underlying asset that is not directly tradeable.

H3: Active investment managers are using options markets to engage in

not significantly different from the universe of funds in terms of performance.

Institute Research Centre of Asia-Pacific. The All Ordinaries Accumulation Index