Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That’s a lot of zeros – $400,000,000,000,000. In contrast, the CIA World Fact Book estimates 2006 Gross World Product at $65 trillion. Said another way, aggregate economic production for the entire world has an approximate dollar value of only 1/6th the estimated market size for futures, options, swaps and various combinations.

Is it any wonder then that regulators are asking questions about who does what in the world of derivatives? One false move and the intricate web of financial institutions which dominate derivatives trading could fall apart. Increased volatility for the market as a whole or an exogenous shock to a particular sector potentially spells trouble.

In her April 4, 2007 article, Wall Street Journal reporter Eleanor Laise writes that “automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds” and that “mutual funds aim to stand out in a crowded field.” She further points out that identifying the use of derivatives by portfolio managers requires a hard look at the fund’s prospectus. I’d emphatically add that reading what is available is seldom sufficient. To the contrary, a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager. Here are a few suggestions from a long list.

1. Who determines the type of permitted derivative instruments and strategies, and on what basis?

2. Does the fund or family of funds have a risk manager? If so, does he or she have the authority to make meaningful decisions about risk controls? Who does that person report to?

3. How are mutual fund traders compensated with respect to return, risk and risk-adjusted return?

4. Is there a risk management policy (and related procedures) that can be reviewed before investing? If considered proprietary, is it possible to meet with the portfolio manager and/or risk manager to discuss?

5. What types of risk metrics are employed by the mutual fund?

6. Who authorizes derivatives-related trading limits, and on what basis?

7. Are the fund’s auditors comfortable with how the derivative instruments are marked-to-market?

8. Does the portfolio manager rely on an external system to analyze and monitor risk? If a proprietary system is used instead, is there an independent party who validates the models and integrity of the data feed?

9. How is liquidity measured? What is the portfolio manager’s plan for liquidating various positions if necessary?

10. Does the portfolio manager have the latitude to switch gears with respect to derivatives-related trading and not have to fully disclose to investors? (In other words, is there a chance that the mutual fund’s use of derivatives in a risk-return sense could differ materially from the stated scope?)

American author Mark Twain once said – “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” While clever, the fact remains. Financial engineering and derivatives are here to stay. Any pension fiduciary not yet familiar with the D-word needs to remedy that situation right away.