Generally, though, they wander the investment circuit in blissful self-assurance.
Whatever their character flaws, without the hedge fund business the equity derivatives sector would still only be playing with simple futures and options. “Their managers are always looking for new ways to achieve what they require in the market and tend to be early adopters a new derivatives,” says David Aldrich, head of Bank of New York’s hedge and broker business in Europe.
Any sort of derivative can be used by hedge funds. Direct demand from hedge funds for these products and ever-more sophisticated product combinations, in turn boosted by increased institutional demand for hedge funds themselves, has seen the equities derivatives market boom.
“The institutional investor embracing of hedge funds is growing as a percentage of portfolio but our research has shown that they are replacing fixed income asset classes,” reveals Mr Aldrich. “Investment managers are looking for funds with fixed income characteristics – returns of LIBOR plus with reduced risk.”
Figures for the US from the Bank of New York and Casey, Quirk & Associates estimate institutional investors are expected to raise their investments in hedge funds to $300bn from $66bn over the next five years, although as more recent indicators show falling performance returns from hedge funds, this rate of take-up may slow.
The implication of these figures should not be underestimated. Firstly, hedge funds are not restricted by regulation on the range of instruments into which they can invest. They are also often designed to be leveraged, allowing them to effectively invest several times their actual assets under management.
“We’d estimate that with leveraging, hedge funds have exposure four times as much as their underlying assets and then their influence way outstrips their exposure,” observes Michael O’Brien at Barclays Global Investors. That’s a lot of clout in any market and made all the more so by being aggressive, as well as strong. With the strength of substantial assets in the marketplace, their aggression is reflected by primarily seeking capital return rather than protection. And, according to financial consultancy Investit, they can churn portfolios at 200 per cent a day.
“They are the real derivative players, searching out mis-pricing discrepancies in the market and finding a tool to most effectively exploit that,” explains Andrea Morresi, head of equity derivates investor marketing for EMEA at JP Morgan. When looking for a product to exploit price discrepancies, for example, they will try and find some way to sell on the risk element of the deal.
“The hedge fund managers make up a huge proportion of buyers of OTC derivatives and the key question to them is what is the correct procedure for valuing derivatives in a hedge fund portfolio,” says Mr Aldrich.
So without the hedge funds search for absolute returns, the derivatives market would be far less sophisticated. Their success in this has made them attractive propositions to other institutions, further boosting the demand for derivatives, but so too making the quest for accurate valuations to exploit more difficult.
EXPLORING THE OPTIONS IN THE DERIVATIVES SPHERE
A recent survey by Investit of the derivatives market in the UK concluded that their use was growing, hand-in-hand with a greater understanding of their use in protecting a portfolio or enhancing its returns. “We’re seeing an enthusiastic investigation of these products by UK institutions and they're set to grow, but we still have concerns over the ability of investing institutions to correctly value underlying assets,” warns Christine Doherty, who supervised the Investit study.
An equity derivative is a product whose value is dependent on the value of an underlying share or group of shares which have their own contract terms and exposures and it is these elements that can create difficulties in valuing the asset.
Derivatives are either listed and traded on recognised exchanges or traded ‘over-the-counter’ (OTC), as a tailor-made product by an institution for a client.
The products usually fall into the following categories:
Options:
Options are the right to buy or sell an item for a pre-set price during a specified period of time and, because this is a deal which can only benefit the purchaser, the seller receives an upfront payment. Buying an option can be regarded as equivalent to taking out insurance – you pay out a premium in advance and if a specified event occurs you get paid.
Futures:
Futures are an obligation to buy or sell something on a specific day for a pre-set price: these can be shares, indices or a basket of equities. It has standardised terms and is traded on a recognised exchange. They are used for leverage in more aggressive funds.
Equity forward:
Contract to exchange an equity or equity basket at a set price at a future date.
Equity swap:
Contract in which one or both payments are linked to the performance of equities or an equity index. It involves the exchange of one equity or equity index return for another, or the exchange of an equity or equity index return for a floating or fixed interest rate.
Equity option/warrant:
Option contract that gives the right to deliver or receive a specific equity or equity basket at an agreed price at an agreed time in the future.
CFD:
A contract for difference is an agreement between two parties to exchange at the close of contract the difference between the opening and closing price of an underlying asset
Dividend swap market: Investors can buy or sell the level of dividends that will be paid on an index in future years.
Correlation trading:
Where investors can buy or sell stock correlation rather than outright volatility. Correlation positions can be synthesised by trading index against single stock volatility.
Variance swap market:
Variance swaps allow investors to trade volatility by buying or selling the variance of stocks or indices (variance being the square of volatility).
