Pension funds and other institutions are upping their demand not only for equity derivatives but for more sophisticated, tailor-made products within the asset class.
Recent figures from the International Swaps and Derivatives Association show a 39 per cent rise to $10,010bn over the first half of 2007 in the notional amount outstanding of equity derivatives, including equity swaps, options and forwards. Growth in the second half of 2006 was 13 per cent, with annual growth to mid-2007 at a dramatic 57 per cent, according to a survey of 88 firms.
Investment managers are “increasingly aware of trying to achieve best risk-adjusted returns”, according to Mike Ward, head of equity derivative flow sales for Europe, the Middle East and Africa (EMEA) at Merrill Lynch.
He explains: “There is increasing pressure on all money managers to deliver real alpha – that does push these managers towards using equity derivatives. Also, more people are looking to get broader exposure to global markets in general. Some markets are hard to access through buying shares, so they are looking to equity derivatives to give them a similar exposure.”
Every investor class is becoming increasingly sophisticated in its use of derivatives, Mr Ward adds. “An example would be derivatives that enable clients to access markets they couldn’t access directly – for example, North Africa. These derivatives can be used for geographical asset allocation or hedging purposes.”
Institutions are becoming more sophisticated, agrees Dan Fields, head of trading, global equities and derivatives solutions, at Société Générale Corporate & Investment Banking (SG CIB). “Institutions fit a different profile than hedge funds,” he says, “but they are not inherently conservative, at least not in the US.”
Demand from uk
Across the pond, Marcel Dupuis, head of institutional sales, equity derivatives, at SG CIB, reports growing demand for equity derivatives from UK pension funds, in light of the mismatch between assets and liabilities following the bear market of 2002-03. Demand differs across Europe as it depends on each country’s equity exposure and equity culture, he says.
Arnaud Sarfati, SG CIB’s head of equity linked structured products, explains: “Typically, in the UK, the pension funds and insurance companies have high equity exposure. Today, they are mainly in a hedging logic. Conversely, French, Italian or Spanish institutional clients traditionally have lower equity exposures. They seek to increase this exposure, with protection. Structured products – which can be capital protected – make sense as equity investments. The development of asymmetrical payoffs remains the common need for these investors.”
Volatility plays
According to Roger Heaton, head of equity sales at Mako Financial Markets, pension funds and insurance companies are thinking increasingly in terms of absolute returns for their portfolios, and are correspondingly more willing to look at volatility as an independent asset class. “It’s no good saying: ‘We are only down 18 basis points and the market is down 20.’ That doesn’t wash any more,” he says.
The end institutions are driving it all, he adds: “They have freed up money for alternative investments. They are looking at volatility plays, arbitrage plays, volatility-arbitrage trades. A number of large insurance companies in Europe have changed their mandates slightly. They only have to free up 1 per cent of their total assets to put a lot into the equity derivatives world.”
Mr Ward also reports growth in demand for volatility-style products, with demand from institutional investors. This is a big departure, as he points out, from traditional equity derivatives with their defined payoffs on external indices.
Moreover, as institutions’ appetite for complexity increases, they demand ever more focused attention from their providers. According to Mr Ward, EMEA in particular has seen increased macro-level demand for tailor-made products.
“This is across all clients, from private banks to institutions to hedge funds. They are all increasingly asking for tailor-made derivatives,” he says.
Big-name players in the equity derivatives market are lining up to launch products to meet demand from investors.
The Merrill Lynch Factor Index fund was introduced in December 2006 in response to just such demand, and is “designed to replicate a passive exposure to a portfolio of hedge funds”. Another example is the Merrill Lynch Fever Fund, which “is designed to give exposure to being long implied volatility on the EuroStoxx 50, or short, depending on your standpoint,” says Mr Ward.
He reports growing interest in this product, which is tailored for institutional clients, as it is perceived as uncorrelated to mainstream investments.
According to Mr Dupuis at SG CIB, the primary area of growth in products over the medium to long term has been “in providing institutions with solutions that improve their risk profile without losing focus on their short-term goal of creating value. This can be achieved through hybrid hedging and access to new asset classes providing potential returns and diversification benefits”.
Bespoke solutions
Mr Dupuis stresses that the majority of SG CIB’s equity derivatives products are tailored to an institution’s needs: “We don’t believe in one solution for all clients.” He adds that the firm has worked with a number of UK pension funds “to help them hedge the main risks to which they are exposed – namely, further drops in equity markets and drops in UK interest rates”.
This is achieved “through innovative hybrid solutions, as well as investment solutions involving structured equity and alternatives, such as hedge funds or private equity, where funds are interested in modifying their current assets”.
Société Générale has also worked directly with insurance companies and asset managers, providing both investment and hedging solutions. Mr Dupuis adds: “Over the last five years, we have provided investors with structures that enable them to access ‘hidden assets’ such as volatility, skew and correlation in a way that cannot be achieved through standard investment routes.”
Last year saw the launch of Timer Call, which claimed to “reinvent” the foundation of equity derivatives, the vanilla call. Rather than fixing maturity, leaving volatility to float, Timer Call fixes volatility and allows maturity to float. The idea is to save investors the extra cost of implied over realised volatility, and systematically optimise market timing. The product’s appeal, according to the firm, extends to the institutional marketplace.
“We started with hedge fund clients just because it is a sophisticated product,” says Stéphane Mattatia, head of engineering for hedge funds, equity derivatives, at SG CIB. “Then we switched to asset managers and then to all types of clients, including institutional clients. A lot of clients could be interested. It is for those who are fed up with paying for implied volatility over valuation levels.”
Other recent product developments include SG CIB’s Summum strategy, which “provides exposure to the highest level reached by the EuroStox Index over a 10-year period” and is very efficient in periods of market downturn, according to Mr Sarfati.
TAILORED TO FIT RISK PROFILE
Institutions are far from being the only investors requiring customised attention from their providers of equity derivatives. Rather, demand is lifted by hedge funds and their much-discussed hybrid cousins, 130/30 strategies.
 | “Historically, hedge funds have been big users of vanilla equity derivatives as a way to get leverage on their directional views but over the last five to six years they have moved very aggressively into more complex statistical trades, such as correlation swaps,” says Dan Fields, head of trading, global equities and derivatives solutions, at Société Générale Corporate & Investment Banking (SG CIB). |
He suggests this is partly because hedge funds themselves have changed, moving away from the long-short equity model. “More complex statistical trades have been developed on the back of the complex risk created in a bank’s books as a result of more structured products,” says Mr Fields.
Mike Ward, head of equity derivative flow sales for Europe, the Middle East and Africa at Merrill Lynch, has also observed a shift by hedge funds into equity derivatives over the past five years. The change in the last year, he says, is the move towards tailor-made derivative payoffs.
“Traditionally, equity derivatives were more used for risk management techniques, trying to balance out the best risk-adjusted return,” he explains. “Now they are saying: ‘We have a particular view on market, can you design a product that will give the best return for the risk we demand?’ There are a lot more solution-based sales.”
Mr Fields agrees, adding that hedge funds that have statistically traded statistical risk “have started aggressively overlay fundamental analysis” over the past few years.
“The way we work with equity derivatives and hedge funds is very one-to-one,” he says. “We don’t create one product and try to sell it to everyone. One hedge fund may be comfortable with US-only; another might want a global basket biased to Japan. It is a very customerised process.”
Classically, equity derivatives are used to hedge a portfolio “by buying a put and financing it by selling a higher strike call, or just buying a put, or using vanilla derivative options to implement a specific view on a stock”, says Mr Ward. But the more sophisticated versions now appealing to hedge funds include best off puts or worst off calls, or volatility-style products, such as variance swaps, which can be used to reflect specific views on volatility.
He says worst off calls give “exposure to a call option on the worst performing of particular stocks. In that case, the hedge fund is saying: ‘I think they will all perform similarly.’ It gives a cheap call option on these stocks.” Similarly, a best off puts product is designed for clients who are “equally bearish on a number of names”.
Such is the demand for these increasingly complex forms of risk, that one challenge facing the industry is to keep up the supply. Hedge funds tend to have a much shorter time-frame for investments than do institutions. SG CIB has been developing hedge fund-like players who are prepared to take the opposite side of hedge fund risk.
