Last week, the Wall Street Journal (WSJ) ran a gripping article about a mutual fund that blew up due to problems with derivatives in the fund’s portfolio.

You can read the whole article by clicking here, but let me start by sparing you of wondering whether you have it: not with us; our portfolio management software doesn’t even recognize the ticker.

The thrust of the story is that the fund, the Infinity Q Diversified Alpha fund, stopped investors from redeeming their holdings in the fund, which is highly unusual for a mutual fund. They stopped redemptions because their investments were illiquid and, as investors learned later, incorrectly priced, sometimes by the Chief Investment Officer.

Clearly, there were a lot of problems with the fund, most notably with their compliance program that had insufficient checks and balances. The fund also got into trouble with derivatives, which is a very broad term that is often thrown around loosely.

I am periodically asked whether we use derivatives, and the answer is no, we don’t. However, some of the funds that we use have derivatives, but not like those used by Infinity Q.

I don’t know exactly how Infinity Q was using derivatives, or what kind they were using, but you can be sure that we understand the derivatives in the funds that we use and how they are used.

One of our largest holdings is the Vanguard 500 exchange-traded fund, which has the ticker VOO. Their most recent filing, as of December 31, 2020, shows that the fund holds common stock worth $634,500,574, which is 99.6 percent of the fund.

The remaining 0.4 percent of the fund is held in cash and is needed for liquidity. Vanguard doesn’t want the cash balance, which is a permanent necessity, to be a permanent drag on the fund, so they use a tiny amount of the fund (0.03 percent) to buy futures contracts tied to the S&P 500, which the fund tracks.

The exposure that they get from the futures contract, a derivative, allows the fund to get exposure to the S&P 500 equal to what they have to keep in cash. This transaction allows the fund to more closely track the index that the fund follows.

The Vanguard 500 fund’s prospectus includes the word ‘derivative’ nine times, and they say that the ‘fund may invest in derivatives (such as futures and swap contracts) for various reasons, including, but not limited to, attempting to remain fully invested and tracking its target as closely as possible.’

We know from looking at the prospectus of the Vanguard 500 ETF that they have minimal exposure to derivatives and that the derivatives they use are liquid and priced by the market (not by themselves, like at Alpha Q).

There are other exposures to derivatives in your portfolio, but they mostly mimic what the Vanguard 500 fund is doing. Bond funds are more complicated because a whole class of bonds are considered derivatives.

We have a very large position in Vanguard’s Total Bond Market ETF (ticker symbol: BND), and the derivatives are listed 67 times in the Statement of Additional Information (a document that accompanies the prospectus).

We’re not bothered by the derivatives exposure here either, because we understand what they are, how they are used, and just as important, how they are not used.

So, when people ask me whether we have derivatives exposure, I say ‘yes, but not really.’ Once I explain how they are used in the funds that we own on your behalf, people realize that it’s nothing like what happened at Infinity Q.