Briefing Notes 33
May 2005




Fine-tuning fund
management
The second survey of the use of
derivatives in European asset
m...
Fine-tuning fund management:
                                             the growing use of derivatives
Financial News   ...
2 | Derivatives in fund management




Fund managers fine-tune their
investment engines
Portfolio management is           ...
Derivatives in fund management | 3




hedging tool, although given where we         derivatives products in order to deli...
4 | Derivatives in fund management




                                           been getting more competent in the      ...
Derivatives in fund management | 5




The second survey of the use of
derivatives in European fund management
Q: How woul...
6 | Derivatives in fund management




                                                                                   ...
Derivatives in fund management | 7




the initial decision to use derivatives,
their expertise develops rapidly as they
 ...
8 | Derivatives in fund management




                                                              Q: In which areas, if...
Derivatives in fund management | 9




Fund managers eager to expand use of
credit derivatives
Investors have been slow to...
10 | Derivatives in fund management




                                          use structured credit products      have...
Derivatives in fund management | 11




Q: In which investment strategies             Most popular derivative strategies
d...
12 | Derivatives in fund management




What proportion of your                       Exchange traded vs OTC products
deri...
Derivatives in fund management | 13




Spanish managers are the biggest
users of OTC products for equity           Reason...
14 | Derivatives in fund management




                                        Futures vs options
                       ...
Derivatives in fund management | 15




managers feel that the opaque nature of            interests of clients. However, ...
16 | Derivatives in fund management




  Using derivatives: from static hedging to
  dynamic asset allocation
  Fund mana...
Derivatives in fund management | 17




example is the case of long/short equity     periods of low volatility. The value ...
18 | Derivatives in fund management




                                         Continued from page 4                    ...
Fine-tuning fund management
Fine-tuning fund management
Fine-tuning fund management
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  1. 1. Briefing Notes 33 May 2005 Fine-tuning fund management The second survey of the use of derivatives in European asset management Sponsored by:
  2. 2. Fine-tuning fund management: the growing use of derivatives Financial News Contents Stapleton House, 29-33 Scrutton Street, London, EC2A 4HU, UK. Tel: + 44 (0) 20 7426 3333 Executive summary 2 Fax: + 44 (0) 20 7377 8927 (Editorial) Fax: + 44 (0) 20 7426 3329 (Advertising) e-mail: letters@efinancialnews.com website: www.efinancialnews.com Subscription orders and customer hotline Fund managers fine-tune their investment engines 2 + 44 (0) 20 7309 7788 or customerservices@efinancialnews.com Subscription 50 issues per subscription year: £245 UK £259 elsewhere (inclusive of The second survey of the use of derivatives in European fund management 5 packing and delivery). Editor James Rutter Advertising Fund managers eager to expand use of credit derivatives 9 James Blanche Art Director Michael Scorer Senior sub-editor Keith Burton Using derivatives: from static hedging to dynamic asset allocation 16 Production Richard Petrie Printed by Colour Quest Methodology 19 Distribution: International Press Network, Air Business, Citipost Registered as a newspaper by Royal Mail. Published by eFinancialNews Ltd. © 2005 List of respondents to in-depth questionnaire 20 All rights reserved. No part of this publication may be reproduced or used in any form of advertising without prior permission in writing from the editor. ISSN 1461 1260
  3. 3. 2 | Derivatives in fund management Fund managers fine-tune their investment engines Portfolio management is Europe’s fund managers are increasingly risks, more creative and sophisticated being re-engineered, with embracing derivatives as they strive to products are required. derivatives playing an match the new demands of investors in increasingly important role, terms of both risk and return. This is the Robert Hayes, head of the strategic conclusion of the second survey of the advice team at Merrill Lynch Investment writes James Rutter. use of derivatives in the European fund Managers, said: “Genuine interest in, and management industry, conducted by physical use of, derivatives has grown Financial News in association with significantly in the last 18 months, both Eurex, the derivatives exchange. within our investment teams and at institutional clients.” Nick Horsfall, a It revealed significant growth in the senior investment consultant at Watson number of managers using derivatives in Wyatt added that he had seen “multiples their portfolios, with 62% of 210 firms of growth in clients wanting to consult surveyed saying derivatives had a role in on derivatives at a strategic level”. their investment approach, compared to just 47% last year. There was a near Beyond the institutional arena, the new 50% increase in the number of managers Ucits III rules governing mutual funds that regarded derivatives as being vital to sold within the European Union allow their activities. more extensive use of derivatives. Many managers are gearing up to offer retail The creative destruction caused by the products that incorporate more bursting of the equity market bubble of sophisticated financial instruments. the late 1990s has prompted fund Aisling O’Reilly, derivatives manager at managers to explore the potential of Gartmore, said: “We are looking at derivatives. They and their clients have introducing credit derivatives in some of realised they can no longer bet their our Luxembourg bond funds under Ucits future on double-digit returns from III. It won’t change the strategy but it equities. To deliver the performance they will give us a bigger toolbox. We are require without taking disproportionate looking to introduce them mainly as a The second survey of the use of derivatives in the European fund management industry: Executive summary ● The proportion of European fund managers using derivatives no longer regard internal risk guidelines derivatives in their portfolios has increased as a significant obstacle significantly over the past year ● Respondents are generally optimistic about being ● One in four non-users expect to start using given greater opportunities to use derivatives in the derivatives in the coming year coming 12 months ● Fund managers from Germany, Italy and Spain are ● Equity index products continue to account for the most comfortable with derivatives. Nordic managers lion’s share of outstanding derivatives exposure. are generally the least inclined to use the products Foreign exchange derivatives have seen a significant increase in use. Credit products remain marginal ● The biggest obstacles to greater use of derivatives are explicit mandate restrictions and ● The expected percentage increase in the use of lack of understanding by clients. Non-users of derivatives in the coming year is much lower than
  4. 4. Derivatives in fund management | 3 hedging tool, although given where we derivatives products in order to deliver expect bonds and credit spreads to go, consistent returns regardless of market that could prove to be very lucrative.” movements. She added that Gartmore had only made Paul Bourdon, head of investor solutions its funds compliant with the new rules in at Threadneedle Investments in London, the first quarter and she expected it to be said: “Traditional fund managers are next year before Ucits III funds really delivering absolute return products and start to take off. “The new rules allow for in doing so they are competing with more interesting strategies, although people who are using derivatives in a much will come down to investor serious way. If the traditional managers demand,” she said. Fund managers have are not using derivatives then they are to comply with Ucits III if they want to going into battle without a full market and sell funds across the complement of weapons.” European Union. While some fund managers have been ‘If the traditional managers are not While retail demand for more complex using derivatives of some form for a using derivatives then they are going investment strategies has yet to be tested, decade or more (Gartmore, for example, into battle without a full complement institutional fund managers are has employed a dedicated derivatives of weapons’ refocusing their operations around manager since the mid-1990s), most are Paul Bourdon, Threadneedle Investments products that rely heavily on derivatives. fairly new to the game. At one end of the risk spectrum this is being driven by liability-driven Expertise is therefore at a premium. investment strategies that promise to Watson Wyatt’s Horsfall said that neutralise the risk of pension funds managers are on a steep learning curve being unable to deliver on their in using fixed income and credit obligations to retired members. At the derivatives. “There are a small number other, absolute return products demand that are much more competent than fund managers master a broad range of most, although a lot of managers have 12 months ago. Respondents are being more commodities have seen a significant shift towards targeted in expanding their use of derivatives. options. Currency trading has moved on-exchange French, German and UK managers are focusing on while commodities has moved off credit products. German and UK managers are also targeting commodities ● Relationships with banks and brokers have become much more important as a driver of OTC ● Existing non-users who expect to enter the use. However, lack of exchange-traded alternatives market will do so across a surprisingly broad range is the main reason why managers use OTC of products products, and has become a more influential factor in the past year. Cost has decreased in significance ● Managers are attaching more importance to derivatives use for return enhancement and for ● Fund managers see the lack of transparent absolute return and hedge fund products. Liability- pricing for OTC products as the biggest risk facing driven products have failed to take off as forecast the derivatives market, followed by a lack of last year understanding by clients and mis-selling by investment banks ● There is clear trend towards greater use of For survey methodology see page 19 options over the past year. Currencies and For list of respondents see page 20
  5. 5. 4 | Derivatives in fund management been getting more competent in the manager, rather than the inherent past year,” he said. advantages of the underlying instrument, that determines success or failure.” Many have turned to the investment banking industry in the search for However, for managers that see experienced derivatives staff. BlueBay derivatives as providing them with new Asset Management, a London-based weapons to beat the market, options- specialist in credit management, hired based strategies are likely to be Alex Khein from Morgan Stanley last attractive. Writing options on stocks to year to build a structured products generate income is one fairly standard team that could add derivatives application for managers who believe a expertise to its fund management share price will not rise, or fall, beyond a operation. Hugh Willis, chief executive specific point. of BlueBay, said: “Sticking a little investment bank on to a portfolio Byron Baldwin, a consultant to Eurex in management company makes sense.” the UK, said: “Options are the alpha instrument for fund managers as they Bourdon was a career investment banker, can capture their view of the market.” ‘Sticking a little investment bank on to most recently at HSBC, before joining a portfolio management company Threadneedle last year. He expects to see There can, however, be resistance from makes sense’ a steady flow of investment bankers fund managers to using options, said following in his footsteps and switching O’Reilly, as the cost of trading can be Hugh Willis, BlueBay Asset Management to the buyside. He said: “Once you give prohibitive if they want to unwind their fund managers the green light to use position. She said that while futures and derivatives you find that there is an contracts-for-difference have become run- exponential growth in use.” of-the-mill products at Gartmore, she spends a lot of time advising fund The most-established use of derivatives managers on options strategies that will at many fund management houses is for deliver exactly what they want without efficient portfolio management. O’Reilly incurring trading costs. said that Gartmore has a range of possible derivatives strategies that are A further problem is that options are presented to clients as a way of making more tricky from a risk management cost savings of between 50 and 100 basis perspective. Futures are fairly points by managing portfolios more straightforward as they have a linear efficiently. pay-off related to the underlying asset or index – their price movements mimic However, she added that it is often a big those of the underlying one-to-one. leap for both clients and managers to go Options have a non-linear pay-off that is from using straightforward exchange- more difficult to model and manage and traded products to streamline the which requires sophisticated software portfolio management process, to using and risk management systems. options and over-the-counter products to put on specific bets or trading strategies. Gartmore is planning to revamp its derivatives operations next year with a She said: “Calculating cost savings from new risk management system that will trading efficiencies is far easier than enable more thorough analysis of the calculating potential returns from different scenarios that can arise when options-based strategies. With the latter it trading options. It had originally is the active decision of the fund continued on page 18
  6. 6. Derivatives in fund management | 5 The second survey of the use of derivatives in European fund management Q: How would you characterise Use of derivatives your use of derivatives as part of Do you use derivatives? your overall investment process? 2005* 2004** European fund managers are No No Yes increasingly using derivatives in their 37.6% 52.5% 47.5% portfolios, although a significant minority – about 40% – continue to shun them. Financial News’ second survey of the use of derivatives by European fund managers saw a significant increase in Yes the proportion of investors prepared to use the instruments. Last year, 52.5% of 62.4% the 200 UK and European fund *210 firms responding managers surveyed said they never used ** 200 firms responding Source: rd;ir/Financial News derivatives. This year, the proportion of non-users dropped to 37.6% of 210 firms. derivatives and the rest, identified in last year’s survey, remains in place. Of the 102 companies, managing €5.7 trillion in assets, that completed a more Fund managers from Germany, Italy in-depth questionnaire, 43 said they and Spain appear to be the most never used derivatives. Eleven of these comfortable with derivatives. Only four managers said they expect to start firms out of 38 surveyed in those derivatives trading in the coming 12 countries said they never used them. months. There was a significant increase However, of the 15 firms from Germany in the proportion of managers that and Italy that completed the full survey regarded derivatives as being vital to questionnaire, none said derivatives Role of derivatives their investment processes. A small but were vital to their investment process, How would you characterise the growing group of asset management whereas four of the five Spanish use of derivatives as part of your firms are rapidly developing expertise in respondents said the instruments overall investment process? derivatives, often by hiring staff from played a vital role in their strategies. Response (%) investment banks. Operating at the most The majority of German managers said 60 sophisticated end of the market, they are derivatives were integral to their 2005 developing products that rely heavily on operations, while Italian respondents 50 2004 derivatives, such as collateralised debt counted them merely as useful. obligations, portable alpha products, and Managers from the Nordic region are 40 liability-driven investment strategies. generally the least inclined to use Many of these traditional firms have derivatives. Of 25 companies from 30 also launched hedge funds alongside Finland and Norway that responded to their long-only products. our general enquiry on the use of 20 derivatives, 17 said they never used However, the biggest group of users was them. Six out of 13 Swedish investors those who find the products merely also shunned derivatives. However, 10 useful. These managers are unlikely to six Swedish managers said derivatives be relying on derivatives to structure were either vital or integral to 0 l l Se l om er ta a fu new products, but rather using them for their investment operations, gr ev Vi se ld te N U efficient portfolio management and to suggesting a wide gap between more In hedge unwanted risks. The gap between sophisticated managers and others Source: rd:ir/Financial News the most sophisticated users of in the country.
  7. 7. 6 | Derivatives in fund management Q: What most limits your ability to Constraints on using derivatives (users) use derivatives in your funds? What most limits your ability to use derivatives in your funds?* Users and non-users of derivatives are Answers generally agreed on the biggest obstacles (3.5) Explicit mandate restrictions (3.6) they face: explicit mandate restrictions Lack of understanding by clients (2.7) and a lack of understanding by clients. (2.3) The two are closely related. Clients who (2.6) Market regulations (2.5) do not understand derivatives are right (2.4) to make sure their fund managers are not Lack of internal systems (2.2) (2.3) using them in portfolios by explicitly Internal risk guidelines (2.0) banning them from mandates. About (2.2) one-in-five European pension funds do Lack of understanding by trustees (1.5) Lack of understanding (2.1) not use derivatives as a matter of policy, by consultants (1.5) according to the Financial News Pension (1.9) Cost N/A 2005 Fund Barometer, a survey of 200 (1.8) 2004 European pension funds published in Lack of internal expertise (1.7) October. Availiability of suitable (1.6) derivative products (1.4) Fund managers may claim that they are 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 as a result missing out on the potential Average score Score 1 to 5 for greater returns, but clients are at the 1= no obstacle same time making sure they are not 5 = significant obsticle Source: rd:ir/Financial News exposed to unexpected and unintended risks. The burden of improving this situation by better educating clients Constraints on using derivatives (non-users) must fall squarely on fund managers and What most limits your ability to use derivatives in your funds?* consultants. Answers A big change from last year’s survey was (3.3) Explicit mandate restrictions (2.6) that fund managers who do not use Lack of understanding by (2.3) derivatives no longer regard internal risk clients (1.2) guidelines as a significant obstacle. (2.3) Internal risk guidelines (3.3) Respondents are generally optimistic (2.1) about being given greater opportunities Lack of internal systems (1.2) to use derivatives in their portfolios over (2.1) Market regulations (1.4) the coming year. Lack of understanding by (2.0) trustees (1.1) Virtually none of the fund managers (1.9) Lack of internal expertise (1.2) surveyed expect to see greater Availiability of suitable (1.9) 2005 restrictions on their use of the derivative products (1.2) 2004 instruments in the next 12 months. (1.7) Cost n/a Rather, about one in four expect Lack of understanding (1.6) improvements in the situation, with the by consultants (1.1) rest thinking it will stay roughly the 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 same. Average score (%) Score 1 to 5 1= no obstacle Existing users of derivatives are much 5 = significant obsticle more optimistic than non-users. This Source: rd:ir/Financial News could suggest that once managers take
  8. 8. Derivatives in fund management | 7 the initial decision to use derivatives, their expertise develops rapidly as they Most-used products become aware of the benefits the By percentage of your outstanding derivative exposure, how is your use products can bring to portfolio of derivatives split between products? management. Users of derivatives are Answers particularly confident that their internal (39.2) Equity index (38.8) expertise and systems will improve over (18.7) the coming year. Fixed income (9.2) (15.7) Individual equity (16.6) Q: By percentage of your Foreign exchange (10.9) n/a outstanding derivatives exposure, (9.4) Interest rate (19.1) how is your use of derivatives split Hybrid stategies (2.6) between different products? n/a (1.3) Credit (2.2) Equity index products account for nearly Commodities (1.2) 2005 (1.1) 40% of the outstanding derivatives (0.9) 2004 Money market (1.9) exposure at European fund management Other (0.1) companies, about the same as last year’s (10.1) figure. Slightly surprising is the 0 5 10 15 20 25 30 35 40 45 extensive use of foreign exchange derivatives, accounting for an average of Average exposure (%) more than 10% of fund managers’ Source: rd:ir/Financial News outstanding exposure. Currency hedging is almost always conducted using favour during the early 1990s, tactical forwards, a fairly basic derivative asset allocation has made a comeback instrument, so this does not necessarily largely on the back of the use of liquid mean that managers are using derivatives that have dramatically sophisticated options-based strategies. reduced the cost of trading and increased the returns on offer. However, dedicated currency management, usually in the form of Credit derivatives remain only a marginal overlay strategies, has become product for fund managers, despite the increasingly commonplace in Europe. rapid growth in the market’s size and Mercer Investment Consulting said it moves towards introducing more conducted more searches for managers of standardisation and transparency currency overlay than for any other through electronic trading platforms and strategy last year. Increasingly, these index products (see article on page 9). strategies are not being employed to Only German-based managers appear to simply hedge currency risk, but to add be embracing credit products, with more excess return to portfolios. than 5% of their outstanding exposure being in the sector. Tactical asset allocation overlays have also enjoyed a renaissance. A poll of 193 Perhaps this should not be surprising. European institutional investors last Traditional fund managers (as opposed to September by JP Morgan Fleming Asset hedge fund managers), have not been Management found that 81% were quick to embrace new derivatives interested in using tactical asset historically. The interest-rate swap allocation to deliver higher returns – market, for example, has been established making it the most popular new for more than a decade yet fund investment strategy. Having fallen out of managers remain only marginal players.
  9. 9. 8 | Derivatives in fund management Q: In which areas, if any, do you expand their use of credit derivatives, Eleven of the 43 expect your use of derivatives to with UK managers leading the way by increase in the next 12 months? raising their exposure by 36%. German non-users of derivatives and UK respondents are also expecting are intending to start Equity index and fixed-income to increase their exposure to trading in the products products will see the biggest increase in commodities products by more than trading by fund managers in the next 20% in the coming year. With both in the coming year 12 months. The expected percentage credit and commodities markets having increase in the use of derivatives is experienced lengthy bull runs, this may significantly lower than last year, when indicate that managers are becoming the majority of respondents were wary of market corrections and are expecting to increase their activity looking to use derivatives to hedge considerably across a broad range of some of their positions. Equally, it products. could suggest that managers are chasing returns and looking to launch For the coming year, respondents are new credit and commodities-based being much more targeted in expanding products on the back of the recent bull their derivatives use. This suggests markets. fund managers, having rapidly developed their expertise in derivatives The threat of motor companies Ford over the past year, are now being more and General Motors having their credit opportunistic in expanding their use. ratings downgraded to junk status (below triple-B), prompted a dramatic Fund managers in France, Germany increase in trading in credit derivatives and the UK are particularly keen to in March and April, as investors looked to hedge their exposure. Those that Product trends for next 12 months were able to do so will have insulated themselves from losses when Standard In which areas and by how much (in percentage terms) do you expect to & Poor’s, the rating agency, cut the car- increase your use of derivatives in the next 12 months? makers credit ratings in early May. Answers (22.0) Eleven of the 43 non-users of Equity index (25.9) (17.3) derivatives are intending to start Fixed income (63.0) trading in the products in the coming (13.5) year. As might be expected, the Credit (41.7) (11.1) majority of these managers will include Individual index (29.3) equity index products in their first (8.5) forays into the market, however many Commodities (55.6) (6.5) also intend to use a broader range of Interest rate (24.4) derivatives. Credit, foreign exchange, Foreign exchange (2.6) individual equity, fixed-income and N/A 2005 interest-rate products will all be used Hybrid strategies (2.4) N/A 2004 by at least four firms moving into (0.8) derivatives strategies for the first time. Money market (16.3) (0.0) This intention to begin trading across a Other (40.6) broad range of instruments suggests 0 10 20 30 40 50 60 70 80 these fund managers will be making Average increase of exposure (%) decisive changes to their investment Source: rd:ir/Financial News operations. Results continue on page 11
  10. 10. Derivatives in fund management | 9 Fund managers eager to expand use of credit derivatives Investors have been slow to take advantage of products Frederic Favre, a trader in the fixed-income advanced active that can insure them against defaults in the corporate bond strategies group at BGI in market, but that is set to change, writes Natasha de Terán London, added: “The CDS market is also incredibly useful to us as a research-intensive Mainstream fund managers have point many more real money house – we are able to extract been slow to embrace credit investors will be able to use vast amounts of information, derivatives, despite the explosive them and we would expect them which is enormously valuable in growth of the market. While to take up the opportunity, as our research processes.” hedge funds have been they are very useful adjuncts to enthusiastic users, helping cash credit investments,” he Another big institutional user of double the volume of credit added. the market is Paris-based AXA derivatives traded to $8.42 Investment Managers. Phillipe trillion last year according to the London-based Barclays Global Berthelot, AXA’s head of euro International Swaps and Investors is one of the few investment-grade fixed income, Derivatives Association, most traditional fund managers to is certain about the benefits of other buyside players have have embraced the instruments credit derivatives. He said: “To remained on the sidelines. That wholeheartedly. Tim Webb, head accurately manage a credit looks set to change. of fixed-income advanced active portfolio today you must use strategies for Europe at BGI, credit derivatives either as a With credit markets expected to said it has only been in the past protection buyer or as a experience more volatile trading two years that the credit protection seller. That is because conditions, following a prolonged derivative market has become the risk in a corporate bond is bull market, fund managers are sufficiently standardised and asymmetric and by using a CDS looking to use credit derivatives liquid for BGI to participate in a you can transform it to a more to hedge exposures and protect meaningful manner. Since then it symmetric asset. These themselves against defaults and has been active in both the US derivatives also allow you to downgrades to corporate credit and Europe. The group traded increase your expected return – ratings. about £9bn worth of derivatives you can take short or long last year and a further £5bn in exposures to the market much Jim Reid, a director in the the first quarter of this year – a more efficiently and fundamental credit strategy good quantity of which were economically than by shorting group at Deutsche Bank in credit default swaps (CDS), the corporate bonds where you face London, said: “So far it would simplest of the credit derivative the challenge of short-covering appear that few real money instruments. your positions in an illiquid and investors are actively using the unpredictable repo market.” instruments, either because their BGI’s long-only funds actively mandates prohibit it or because trade CDS, using them as longer- An additional benefit pointed to they are naturally risk-averse term portfolio overlays and for by Berthelot, is the ability that and perceive the instruments as hedging purposes. Its long-short credit derivatives give traders to being risky.” credit fund uses them for pairs put on name-specific trades. For and relative value trading, as instance, he said that selling Instead Reid said the bulk of well as curve trading – things five-year protection on activity has come from banks that Webb said were not fully carmakers BMW or Peugeot and hedging their loan portfolios and practicable in the credit markets buying five-year protection on from hedge funds that are more before the advent of a liquid Volkswagen was a profitable actively trading them. “At some credit derivatives market. trade at the start of the year.
  11. 11. 10 | Derivatives in fund management use structured credit products have raised concerns about the such as tranched iTRaxx index market’s associated risks, while products within our long-short rating agency Fitch and others fund.” have questioned the market’s liquidity. Yet those involved in AXA’s Berthelot added: “The the market are confident the iTraxx indices are incredibly concerns are overblown. useful. They offer investors a very quick and efficient method BGI’s Webb believes that the of getting into or out of the advances in the ISDA Berthelot: indices enable managers market or its sub-sectors. In a documentation and reference to put on trades that would single trade we can put on or entity cleaning processes will previously have been very reduce exposure to 125 have reduced the risks that were complicated, and costly, to execute reference entities and with the once more prevalent in the sectoral indices make relative market, and will serve to value plays between industries. eliminate the sort of disputes “Not only that, someone doing The bid-offer spread is now that occurred during its earlier this trade would have been between 0.25 and 0.75 basis stage of development. He said: making a pure play on the points, which makes them a “Now that the market and spread differential and would very, very interesting tool documentation are very have benefited, irrespective of for us.” standardised, there are no more the direction the rest of the risks involved in trading these market or rates took in the Berthelot said the indices enable instruments than there are in interim.” managers to put on trades that trading corporate bonds. would previously have been very Naturally there is counterparty The dealer community is hoping complicated and costly to risk, but we operate within strict that the launch of credit execute. “An investor wanted to counterparty limits – and always derivative indices will encourage increase his market exposure, ensure we have good institutional investors to get without increasing the level of diversification across all involved in the market. The his cash exposure. Using the counterparties and derivative indices trade under the iTraxx iTraxx route we were able to do products.” and CDX banners and were just that in a single trade – by developed over the past two selling protection on the iTraxx Webb is equally confident that years by dealer-owned groups. index he immediately had the market is now sufficiently Based on CDS, the tradeable exposure to the 125 names, but mature for liquidity to remain indices are designed to increase his cash position was robust in times of stress as it transparency and serve as unaffected.” Without the index, proved earlier this year. He said: benchmarks for the Asian, Axa would have had to execute “Liquidity always varies European, US and emerging 125 separate trades – an especially after sharp intraday market areas. unfeasible proposition. moves, but during March when there was a marked increase in BGI’s Favre said: “We mostly Liquidity, market, credit and volatility and credit specific use single-name CDS, but also operational risks are key events, we were able to trade use the indices because of the concerns for any investor throughout and the bid offer high liquidity and tight bid-offer considering using credit spreads on the CDS indices did spreads in the products. The derivatives or any other form of not really widen. Even on some iTraxx indices offer an efficient over-the-counter derivative. of the more troubled names and easy means of allocation Regulators, including the UK’s there were good two-way and in the future the plan is to Financial Services Authority, spreads in reasonable size.”
  12. 12. Derivatives in fund management | 11 Q: In which investment strategies Most popular derivative strategies do you make most use of derivatives? In which strategies do you use derivatives?* Answers Fund managers are generally attaching (3.3) Overlay (2.9) greater importance to derivatives, (3.2) suggesting they have grown more Hedging (2.7) comfortable with using them over the (3.1) Cash management (2.9) past year. General product trends remain (2.8) the same, the most popular strategies Return enhancement (2.3) being overlays, hedging and cash (2.5) Absolute return/hedge funds (2.2) management. These could all be seen as (2.2) being at the more conservative end of Improving trading efficiencies (1.8) the spectrum of derivatives strategies. (1.9) Alpha transport n/a Overlays and hedging strategies are (1.8) often used for risk management Liability driven investments (1.8) (although currency and tactical asset (1.5) 2005 Tax efficiency (1.0) allocation overlays are increasingly 2004 Transition management (1.3) being used to add excess returns), while (1.3) cash management strategies tend to 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 involve the straightforward equitising of Average score cash through the purchase of futures. *Score 1 to 5 1=do not use 5=use constantly However, managers are attaching Source: rd:ir/Financial News considerably more importance to the use of derivatives for return enhancement use derivatives to hedge or take short and for absolute return and hedge fund positions. Managers expect next year to strategies. A simple return-enhancement see a greater number of such fund strategy might involve a fund manager launches. writing calls on individual stocks in their portfolio that they believe have Given the focus that fund managers peaked for the time-being, but continue have been putting on liability-driven to favour as a long-term investment. The investments, it is surprising that these manager receives a premium for the call, strategies have not become more although gives up any upside if the important over the past year. This stock rises above the call price. would suggest slow take-up from clients. Respondents last year were expecting to There is a steady stream of traditional see growing demand for liability-driven fund managers launching hedge funds derivative strategies. This has clearly alongside long-only products, which failed to materialise, although fund inevitably involve greater use of managers reported a considerable derivatives. The new Ucits III rules that upturn in execution of such strategies govern funds distributed across borders during the first quarter. in Europe have opened the door to greater use of derivatives in retail- For non-users of derivatives, the targeted products. Morley Fund potential to better manage risk is clearly Management, Baring Asset Management the primary attraction of moving into and Merrill Lynch Investment Managers the market. Hedging is by far the most are among the companies that have enticing strategy for those managers not already launched Ucits III funds that can yet using the products.
  13. 13. 12 | Derivatives in fund management What proportion of your Exchange traded vs OTC products derivatives trading is done What proportion of your derivatives trading is done through exchange- through exchange-traded traded products and what proportion is done through OTC products? products and what proportion is done through OTC products? Areas 73.7 26.3 Fund managers continue to favour Individual equity 75.1 24.9 using exchange-traded products for the vast majority of their derivatives 86.2 13.8 trading. The main reasons they prefer Equity index 85.1 14.9 trading through exchanges rather than in the over-the-counter market are the 77.2 22.8 benefits of having a central Fixed income 70.3 29.7 counterparty and clearing house; the transparency in trade and settlement 61.4 38.6 prices; and the additional liquidity that Interest rate comes through standardisation of n/a derivatives contracts. 74.5 25.5 Money market However, one-in-10 managers cited 76.1 23.9 mandate restrictions as the reason why they tend to use exchange-traded 38.8 61.2 Foreign exchange rather than OTC products. Institutional 34.5 65.5 investors are often concerned about the counterparty risk they are exposed to 62.2 37.8 Commodities in the OTC market, as well as the 83.8 16.2 documentation and cost involved in 0 20 40 60 80 100 transactions. Exchange 2005 (%) OTC 2005 (%) Only in the foreign exchange market is Exchange 2004 (%) OTC 2004 (%) more business conducted away from exchanges than on them, as was the Source: rd:ir/Financial News case last year. The liquidity in the OTC currency forwards market continues to overshadow that provided by German managers conduct the exchange-traded futures, although majority of their commodities there has been a slight shift towards business in the OTC market, and more trading on exchanges in the past year. than 30% of fixed-income business off-exchange. The biggest trend suggested by this year’s survey is a shift away from For individual equity derivatives, exchanges for commodities business. Swedish and Swiss investors use OTC The proportion of derivatives trading products for the majority of their done in the over-the-counter market trading while Italian managers has more than doubled in the past conduct nearly 40% of their business year as managers have looked to off-exchange. Dutch managers look to execute tailor-made strategies to take the OTC markets to conduct two advantage of, or hedge against, thirds of their interest-rate derivatives surging commodities prices. business.
  14. 14. Derivatives in fund management | 13 Spanish managers are the biggest users of OTC products for equity Reasons for using exchange-traded products index derivatives, conducting more When you choose to use exchange-traded rather than OTC is it because? than a third of business away from exchanges. UK-based managers 2005 (2004) Benefits provided by the execute more than a third of their counterparty/clearing house fixed-income and interest-rate business 22% (22.2%) in OTC markets. Other 3% (2%) Trade anonymity 3.3% (9.9%) What are the reasons for using Credit risk OTC rather than exchange- 9.3% (n/a) traded derivatives? There is a focus of liquidity through standardisation 22.7% (30.2%) The lack of exchange-traded alternatives is the main factor driving Mandate restrictions 10.7% (n/a) investors to the over-the-counter Transparency in trade market and has become more and settlement prices important over the past year. 30% (37.7%) Fund managers are often reluctant to Source: rd:ir/Financial News shoulder the larger execution costs to which they are exposed in the OTC market, particularly if they want to unwind a position before it expires. Market impact and discretion is a significant factor in choosing OTC products for a minority of respondents Reasons for using OTC products – mostly the more sophisticated users When you choose to use OTC rather than exchange-traded derivatives of derivatives – while the cost benefits is it because? of trading off-exchange have decreased 2005 (2004) in importance since last year’s survey. The required products are not available as exchange-traded Relationships with banks and brokers products 58% (45.3%) have become a much more important Other factor in driving managers to the OTC 1.6% (n/a) market. As fund managers become Market impact/dicsretion more sophisticated users of derivatives 1.6% (n/a) they are likely to develop much There is a measurable indirect stronger relationships with a small cost benefit (bid/offer spread) 6.5% (13.5%) group of banks. There is a measurable direct cost benefit 11.3% (16.3%) An informal poll of the survey respondents revealed Deutsche Bank, There is a strong relationship with the bank or broker in JP Morgan and Merrill Lynch as the other areas 9.7% (2.3%) three most-favoured counterparties, Source: rd:ir/Financial News followed by Citigroup, Dresdner Kleinwort Wasserstein and UBS.
  15. 15. 14 | Derivatives in fund management Futures vs options What proportion of your derivatives trading is done in futures and what proportion is done in options?* Areas 30.0 70.0 Individual equity 38.9 30.0 75.1 24.9 Equity index 70.7 29.3 Fixed income 77.1 22.9 81.7 18.3 78.7 21.3 Interest rate n/a 73.6 26.4 Money market 80.2 19.8 Foreign exchange 59.0 41.0 65.2 34.8 52.5 47.5 Commodities 64.4 35.6 0 20 40 60 80 100 Average (%) Futures 2005 (%) Options 2005 (%) Futures 2004 (%) Options 2004 (%) Source: rd:ir/Financial News What proportion of your exchange- options is more common than futures, traded derivatives business is done with options becoming more dominant if futures and what proportion is over the past 12 months. Single stock done in options? futures have clearly gained a significant following, but the arguments in the There is a clear trend towards the favour are far from compelling for many greater use of options over the past year. managers. Futures continue to be the preferred product for fund managers, but only in The biggest shift towards greater use of equity index products has the use of options is in the currencies and futures increased. In all other areas there commodities markets. has been a shift towards options. What do you perceive to be the Given that options are more complex biggest risks in derivatives products than futures, with valuation markets? and risk management both more demanding, it underlines the growing The lack of transparent pricing for over- sophistication of fund managers. the-counter products is regarded as the Trading in individual equity products is biggest risk in the market by both users again the only area where the use of and non-users of derivatives. Fund
  16. 16. Derivatives in fund management | 15 managers feel that the opaque nature of interests of clients. However, the fact the OTC market invariably plays into that users of derivatives also see this as Investment banks the hands of investment banks, which a significant risk suggests that clearly have some way can cream off fat spreads for buying, participants in the derivatives market selling and creating products. It also need to increase their efforts to educate to go before buyside means that the risk involved in the trade pension funds and other end clients users of derivatives are can be hard to assess and price about the benefits and risks associated convinced that their accurately from the clients’ perspective. with the products. conduct is above-board Investment banks clearly have some UK-based managers saw operational way to go before buyside users of failures and the rapid growth in credit derivatives are convinced that their default swaps and collateralised debt conduct is above-board. The danger of obligations as being jointly the second banks mis-selling complex products is most significant risks after lack of seen by users of derivatives as the third understanding by end clients. biggest risk in the market, behind the systemic risk that a counterparty might Respondents’ concerns over CDOs collapse. proved well-placed given that the subsequent downgrades to the credit Non-users of derivatives regard a lack ratings of car-makers Ford and General of understanding by end clients as Motors caused problems in the CDO being jointly the biggest risk facing the market. The focus on operational issues market. Arguably, this is a safe refuge came on the back of a warning by the for fund managers that do not use Financial Services Authority, the UK derivatives, as it gives them an excuse regulator, that more could be done to for not exploring the potential of the reduce operational and settlement risks market – that they are acting in the best in the credit derivatives market. Biggest risk What do you think is the biggest risk in derivatives markets?* Answers Lack of transparent pricing for (2.8) OTC products (2.8) Systematic risk (promoted by (2.7) collapse of counterparty) (2.8) Investment banks mis-selling (2.6) complex structured products (2.6) Lack of understanding leading clients (2.5) to purchase inappropiate products (2.4) (2.5) Operational/back office failures (2.4) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Average score Non-users Users Score 1 to 5 1= no risk 5 = big risk Source: rd:ir/Financial News
  17. 17. 16 | Derivatives in fund management Using derivatives: from static hedging to dynamic asset allocation Fund managers are Fund managers are making increasing dynamic asset allocation is typically looking to make greater use of derivative products. Academic considered for inclusion in the satellite use of derivatives for the studies have found that roughly one third portfolio by investors since the goal is to of retail investment funds make use of generate alpha. Derivatives have a range benefit of investors, derivatives1. In the European Union, the of different uses in such strategies. writes Felix Goltz, Ucits III reform governing mutual funds research engineer with has brought about important changes Implementing timing strategies the Edhec Risk and facilitating investment in exchange- Index derivatives are a natural way of Asset Management traded and OTC derivatives. It is gaining short-term exposure to an asset expected that the use of derivatives will class. For example, if the manager Research Centre assume greater importance in the future predicts that equity returns will be high as a result of this and other new in the coming months, he may buy an regulations. In addition, hedge funds, index futures contract in order to increase which make intensive use of derivative his portfolio’s exposure to equities. Rather instruments, are continuing their strong than just using such simple market growth in assets under management. As timing strategies, a manager may use a consequence, a wide range of players in futures on different segments of the stock the asset management industry are market (investment styles or industry asking if and how derivatives can be sectors) or bond market (maturity used for the benefit of investors. segments or rating categories) in order to implement bets on the relative A simple way to benefit from derivatives performance of such segments. The main is to employ stock index options to hedge advantage of using futures is low an equity portfolio. Such protective transaction costs in comparison to buying derivatives strategies allow a fund to baskets of securities. Futures thus offer a profit from the equity risk premium and cost-efficient tool for strategies that thus generate returns for investors, frequently change exposure. without being fully exposed to the downside risk associated with investing For example, Amenc, Malaise and in the stock market. Martellini (2005)2 present a timing strategy between maturity segments of Active asset allocation the bond markets using the Eurex Euro Going beyond simple hedging Bund and Eurex Euro Schatz futures. approaches, derivatives may be used in They emphasise that derivatives can be active asset allocation. While most employed not only for generating and investors favour a static approach to delivering abnormal performance (alpha asset allocation where the weights benefits), but also for packaging such attributed to different asset classes stay performance in a way that is consistent constant over long periods, academic with the modern core-satellite approach studies suggest that investors can reap to institutional portfolio management. In significant benefits from dynamically fact, the alpha generated from rotation rebalancing their holdings as market strategies can be transported to a core conditions change. In particular, such portfolio invested in a broad-based index strategies allow the investor’s views on (possibly through a derivatives position) future returns, as supported by such as a medium-term bond index. econometric models, to be exploited. Shifting exposure to asset classes over Neutralising active bets short horizons is sometimes referred to as Another use is to neutralise the bets that tactical asset allocation (TAA). Such a manager takes unintentionally. One
  18. 18. Derivatives in fund management | 17 example is the case of long/short equity periods of low volatility. The value of percentage of months with negative hedge fund managers. Since the an option, on the other hand, increases returns on the strategy to be reduced. majority of these managers favour a with volatility. This suggests that bottom-up process of pure stock suitably designed option strategies Conclusion picking, they do not generally actively would allow global portfolio risk to be Derivatives have long been regarded as manage their market exposure and thus reduced when they are added to a hedging instruments, in part because have a net long bias. This can be seen dynamic allocation strategy. regulation limited their use to this. More for example from the correlation of the recently, however, the value of HFR Equity Hedge index (a prominent There are actually a number of reasons derivatives as asset allocation tools has index for long/short hedge fund why trendless periods of the market been noted. Cost-efficient managers) with the S&P 500, which cycle are typically difficult market implementation of tactical asset was 0.63 based on monthly data over environments for tactical asset allocation strategies through futures the period from 1990 to 2000. This long allocation strategies. Obviously, it is and diversification of such strategies bias, which is not the result of an active easier to predict significant market through short volatility options bet on a bullish market but merely the moves, as opposed to small changes in strategies are but two examples. The result of a lack of perceived trends that can easily be confused with increasing range of new derivatives opportunities on the short-selling side, noise. Also, if the market experiences a contracts such as credit derivatives or has undoubtedly explained a large series of short-term reversals within a derivatives on volatility means that fraction of the performance of these given time frame, the model’s prediction, investors will have new tools to explore managers in bull market periods. On the based on the previous subperiod, will for use in their investment decisions. other hand, it has hurt their fail to forecast the right direction. While these instruments are currently performance very significantly in Finally, even if the model yields correct used mostly for hedging motives, the periods of market downturns. predictions, they are of little use if the potential use in asset allocation will return spread between assets is small. certainly raise new questions on Similarly, long/short managers, even investment practices and on the those who target market neutrality, have In order to have an options strategy suitability of current regulations. unintended time-varying residual that yields positive returns in calm exposure to a variety of sectors or markets, it has to involve short Footnotes investment styles resulting from their positions in options. Amenc, Sfeir, 1 Koski J and J Pontiff, 1999, How are stock picking decisions. Futures Malaise and Martellini (2004)3 propose derivatives used? Evidence from the contracts can be used to correct for such to construct a strategy that is suitable mutual fund industry, Journal of unintended biases and ensure that the for addition to a European market Finance, 54, 2, 791-816 portfolio’s factor exposure is consistent timing strategy that has the Dow Jones with the manager’s active views. In the Euro Stoxx 50 Index as a benchmark. 2 Amenc N, P Malaise and L Martellini, case where the manager has no views The options strategy they choose 2005, From delivering to the packaging on systematic risk factors, it is involves a “top strangle”, which allows of alpha, illustration of active bond recommended that managers use an investor to take a short position on portfolio management: using fixed- derivatives products to neutralise the volatility. So as to control the risk of income derivatives to design hedge fund exposure of the portfolio with respect to potential loss in the case of a large type offerings that better fit investors’ such factors. change in the underlying asset value, a needs, working paper, Edhec Risk and “bottom strangle” position is added. By Asset Management Research Centre Complementing timing strategies construction, the options strategy will In addition to exposure to asset classes perform well in periods of low 3 Amenc N, D Sfeir, P Malaise and L through futures, options may be used in volatility, and will perform poorly in Martellini, 2004, Portable alpha and the context of dynamic trading periods of high volatility, while limiting portable beta strategies in the euro zone – strategies. A possible use of options losses. For the European market timing implementing active asset allocation arises from the fact that tactical asset strategy, adding this options strategy decisions using equity index options and allocation usually performs well in leads to an increase in the Sharpe Ratio futures, Journal of Portfolio periods of high volatility and poorly in from 0.58 to 0.8 and allows the Management
  19. 19. 18 | Derivatives in fund management Continued from page 4 pension funds when it came to using planned to introduce the system for its derivatives that needed to be overcome. €6bn of hedge funds but given the “It is a matter of them getting used to advent of Ucits III decided it would be the fact that more than 90% of the needed across its whole business. FTSE 350 companies use derivatives, so Operational issues can often be a big why aren’t their pension funds?” constraint for fund managers seeking to use derivatives. Respondents to this There are, however, clear signs of an year’s Financial News survey said they increase in activity this year. The had become more of an obstacle over launch of pooled swaps funds by the the past 12 months. “Often it comes likes of Barclays Global Investors and down to whether your operations, your Fortis Investments, with more in the systems, your legal team, can cope with pipeline, has given investors an easy derivatives,” said Bourdon. entry point to the market that does not require them to closely manage best Installing systems and procedures to execution, counterparty risk and legal handle derivatives is high on agenda of documentation – although they still many traditional fund management need to get comfortable with the houses, according to Nick Kent, concept and risk of swaps. ‘Saying it is too hard, too complex or managing director at Business Fidelity, too opaque is just not good enough in a London-based consultancy Currie believes this battle is largely this day and age’ specialising in asset management. He being won: “Most people are buying said fund managers are particularly into the fact that plain vanilla swaps are Nick Horsfall, Watson Wyatt keen to be able to use credit default a more efficient tool for matching swaps – derivatives through which liabilities than bonds,” she said. users can buy and sell insurance on corporate bond issuers defaulting on Merrill Lynch’s Hayes said it was their debt. inevitable that take-up of liability- driven investment strategies would be The Financial News survey suggested fairly slow, not only because of the that the use of credit derivatives has yet education required to get pension fund to take off among traditional fund trustees comfortable with the concept, managers, despite the huge volumes but because execution depended on being traded in the instruments by underlying markets being at attractive investment banks and hedge funds. levels. Credit derivatives accounted for only 1.3% of outstanding derivatives He said: “Growth in derivatives volumes exposure on average, although is currently being driven by our target managers in the UK and Germany return product area. Do I still expect expect to increase their activity considerable growth in interest rate and significantly in the sector over the inflation swaps? Absolutely. It is a coming year. question of timescale, rather than of will they or won’t they be used.” The survey also showed that the use of derivatives for liability-driven investment Watson Wyatt’s Horsfall is dismissive of strategies had failed to grow as quickly those institutions that continue to resist as managers expected 12 months ago. the greater use of derivatives by fund Kathleen Currie, director of structured managers: “Saying it is too hard, too solutions at Axa Investment Managers, complex or too opaque is just not good said there was a degree of inertia among enough in this day and age.”

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