The revolution feeding equity risk appetite

Three years before the financial crash, this 2005 article for FT Mandate explains how derivatives had become a common-place investment strategy for pension funds.

Equity derivatives have made massive progress in traditionally untapped markets partly due to institutions having to reduce their equity allocations but not wanting to. Gerry O’Kane charts the rise of the asset class and provides an insight into the different types of products on offer.

It is always bad for business, any business, when the company’s chief executive is marched off to the police station. It gets worse when the share price falls 74 per cent in four days and rumours confirm that clients are half a billion dollars worse off.

In truth, the recent Refco affair had little to do with poor investment decisions, but because it was mainly a full-service hedge fund futures broker. The traditionalists’ public distaste for derivatives made a hasty come-back.

Whatever the sceptics might say, equity derivatives are making huge inroads into markets that never before directly used these sorts of instruments. The International Swaps and Derivatives Association’s (ISDA) latest global figures show that the notional outstanding volume for equity derivatives, which consist of equity swaps, options, and forwards, grew by over 28 per cent from $3790bn (€3218bn) to $4830bn from mid-2004 to mid-2005.

Eurex shows huge voume increases

But figures for this sector are never straight-forward. The ISDA does not break-out European demand, however figures from Eurex – one of the main quoted European marketplaces – show huge new volumes of trading. Index and equity derivatives have increased by more than 100 per cent over the past five years and even 17 per cent year-on-year.

Another indication of the health of the sector is that banks do not spend unless they believe they will earn. Earlier in the year, the Boston Consulting Group identified equity derivatives as a growth area. It claimed the sector would deliver revenues of more than $20bn by 2007, more than 40 per cent up from last year’s estimated figures.

These huge revenues (with claims that some specialised over-the-counter (OTC) contracts could realise margins of 45 per cent) go some way to explaining the re-jig to create Crédit Agricole Structured Asset Management several months ago. It was set up as a standalone venture to sell structured and alternative investments to corporate and institutional clients. It was to compete with BNP Paribas and Société Générale, through Lyxor Asset Management, who are recognised as having built a solid European derivatives business and are successful in their competition with the US houses.

Meanwhile, their US rivals have been busy swapping staff and June saw 23 derivatives staff defect from JP Morgan to Merrill Lynch.

So along with the huge increase in hedge fund business, which itself is finding its way into once-conservative institutional portfolios, new legislation allowing European pension and mutual funds greater investment flexibility and greater investment sophistication, means the market is on the up.

Sophisticated market

“The European market is quite advanced, more sophisticated than many others and driven by a retail market,” says Onno Vriesman, chairman of the ISDA’s equity derivatives committee and managing director with Deutsche Bank’s equity derivatives arm.

This mention of the retail side might surprise some. However, since the range of equity derivatives is vast, their use for retail investment, especially in France and Italy, is substantial. The knock-on effect of retail buyers is that it improves market liquidity for the institutional players.

Research from Greenwich Associates shows that European institutions are structuring customised OTC/securitised/hybrid product trades for third-party distributors. They pass these products on to the retail market. It says the proportion of European institutional investors active in customised OTC, securitised and hybrid derivative products stood at 85 per cent in 2005.

So what has driven this revolution? How are European institutional investors using equity derivatives?

“I think the events of 2000 helped, as some institutions faced being forced to reduce equity holdings but didn’t want to and they started to see that equity derivatives could do this without getting rid of equity and their appetite to risk could be incorporated into the product,” says Christian Kwek, head of institutional client coverage in equity derivatives at BNP Paribas.

Complexities are often hidden

“Generally, investors use derivatives for the same reasons they invest in any financial asset,” explains Peter Allen, equity derivatives’ strategist with JP Morgan. “They seek to reduce risk or enhance returns. The particular attraction of derivatives is that they can give investors access to risk/return profiles that are otherwise very difficult for investors to achieve.”

This relatively straight-forward summary of derivatives use hides the complexity of the strategies the investment houses now use to achieve either goal. “You now have so many different building blocks which you can mix any way to produce a derivative,” agrees Mr Vriesman. In general though, tailor-made OTC products aim for a fixed strike price (of the underlying equity) or a maturity date. If certain equity conditions are met, you get paid.

At the top of the derivative feeding chain is the hedge fund manager. They use any product available and are generally the drivers of product sophistication, approaching players like JP Morgan or BNP to produce an OTC derivative that either reflects their view of future market movement, or to exploit price discrepancies found elsewhere. Generally, they leverage their underlying assets to a far greater degree than any other institution would consider sensible, but that is the hedge fund business.

Then there are the investment houses and mutual funds. “These more traditional managers use them on a different scale,” explains David Aldrich, head of Bank of New York’s securities industry banking. “They’ll utilise some OTC products but more as a hedge across their entire portfolio risk/return profile.”

“When the asset mix strays from the strategic outlook, for example you’re four per cent overweight in US stocks, then you’d sell an S&P future to reflect that overweight risk,” says Michael O’Brien at Barclays Global Investors. He points out that as pension managers now deal with any number of individual asset managers, this use is vital in avoiding either losing your strategic position or a churn of managers.

Mr Kwek agrees this sort of use is growing and is increasingly important. “Major European pension funds are using derivatives for protection across all their portfolios, giving protection against downside movement based on their strategic view, say against interest rates. We’re certainly starting to have more discussions along those lines with insurance companies which have a need to manage cash-flow in a fluctuating equity markets.”

Nordic advantage

In general the pension funds are getting exposure through trying to manage risk and cash-flow but with derivatives held in a separate portfolio. Like the insurance sector, the speed and sophistication of take-up varies from one European market to another. According to Mr Allen, the UK is considered something of laggard in equity derivative use, apart from hedge funds, while the Nordic countries and the Netherlands have a reputation for sophisticated and widespread use, even in the pension fund market.

However, one research report from financial consultancy Investit shows that equity index futures were steadily increasing in use with 80 per cent of life companies and 60 per cent of pensions in the UK, using them. Only 30 per cent of pension funds used single stock futures.

But pension funds and some asset managers are also using the system to get them exposure to difficult markets or performance. Dividend swaps, for example, means that rather than buying the underlying equities or an index, you buy the dividend performance over a period, operating a more complex contract for difference. Often this sort of product increases the risk/valuation calculations for the funds, but they do offer operational simplicity (rather than having to buy all the index shares in China, for example).

The growth of the listed equity derivative markets and its use by more conservative investor groups is apparent. During 2005, Eurex expanded its range of derivatives products on European equity indexes with tailor-made trading and hedging instruments for mid cap and large cap indexes – DJ STOXX 600 (futures and options), DJ STOXX Mid 200 (futures and options), MDAX (futures on German mid-caps) and SMIM (futures on Swiss mid-caps).

“Due to the above-average performance of mid caps, there has been a surge of interest from private and institutional investors, with our clients having a strong interest in trading our European bluechip equity derivatives, such as those based on the DJ Euro STOXX 50 and its equity components,” reports Frank Hartmann, a spokesman for Eurex. He adds that sector derivatives have also shown strong growth in the last couple of months as investors increasingly use these instruments to gain additional alpha.

Huge demand

According to Mr Vriesman, this follows after huge demand for capital guaranteed products post-2000. Others also believe we are beginning to see new shifts in investment perspectives and uses of derivative products.

“We’ve been seeing growth in most equity markets for some time now and a lot of funds are implementing protection strategies,” points out Mr O’Brien. Mindful of the crippling effects of losing the massive gains in equity markets up until 2000, they do not want to make the same mistake and are looking to lock in their gains through a series of actions, selling a call at a specific level and buying a put at another level.

Another method is the increasing use of correlation and volatility trades. “For example, volatility typically rises in bear market, so holding along volatility position – being long variance swaps – can help to hedge an equity portfolio,” explains Mr Allen.

These sorts of equity derivatives are more common, with variance swaps allowing investors to trade volatility by buying or selling the variance of stocks or indices. So too are correlation options based on the relative performance of the underlying assets.

Eurex launched the first European volatility futures based on the DJ EURO STOXX volatility index (VSTOXX), the DAX volatility index (VDAX) and the SMI volatility index (VSMI) recently in answer to increased demand. Prior to this, all contracts would have been OTC.

Haunting issue

One issue still haunting the sector is in valuing some of the more complex OTC products. Catherine Doherty, who researched the derivatives market for Investit, questions whether some of the newer users of these products can truly value the structure they’ve bought, at least in the OTC market. “They don’t do the third level analysis and accept the price on the underlying assumptions, generally asking the person who sold them it,” she says.

When there are difficulties with equity derivatives, it is often not the investment product, but the investment manager’s level of understanding and skill. “In many cases it is not just the instrument but the user, it’s a bit like blaming a Ferrari for a crash. The car is great, but unsuitable for the driver’s level of experience,” says Mr Vriesman. He also points out that if products on the market are priced incorrectly, it is a good opportunity for others in the industry to enter with a new competing product.

Mr Kwek agrees too that mistakes are made in derivative usage but: “BNP doesn’t want to risk its reputation by misleading a client and we make serious efforts to make sure products suit the clients’ needs”.

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