1. Trade Ticket
Pg. 25
York–based head of the global team. “We
give them the resources to do so.” Using a
proprietary screening tool, Zabaleta’s team
uncovers opportunities for clients to hold
positions more tax-efficiently or gain lower-
cost exposure to a group of securities or an
entire market.
This service is yet another outgrowth
of the explosion in the use of derivatives in
everyday portfolio management. The Inter-
national Swaps and Derivatives Association
estimates that the outstanding notional
amount of equity derivatives at the end of
2006 was $7.2 trillion, up 29 percent over
the previous year. (The market for interest-
rate derivatives and credit-default swaps is
more than 40 times as large, and growing
even faster.)
While derivatives have been called many
things, they are merely tools designed to
shave residual costs that can eat away at the
alpha portfolio managers work so hard to
generate. As Zabaleta tells clients, “You
make the decision to be long or short, but
we can tell you the most economical way
to hold the position.” Creating so-called
synthetic positions through the use of de-
rivatives can provide a number of advan-
tages to a portfolio manager, including
cheaper, more efficient ownership struc-
tures, access to markets that are otherwise
inaccessible on the long or short side, tax
advantages and operational efficiencies.
SECTOR ALTERNATIVES
EXPRESS YOURSELF Though stocks offer the most direct form of
security ownership, they are not always the
How synthetic structures can enhance your returns without changing your investment thesis. least expensive way to put on a position.
The same can be said for exchange-traded
b y d av i d l a n d i s funds, or ETFs. ETFs seem like a cheap and
PHOTO ILLUSTRATION BY KARJEAN LEVINE
easy form of ownership that save trading
commissions and index-rebalancing costs.
I
t may seem counterintuitive that Merrill Lynch’s equity-product market- However, ETFs come with their own set of
a hedge-fund manager who can ing team serves as a kind of efficiency con- costs, including management fees and a
squeeze big profits out of a few sultant to portfolio managers who are market price that can stray from the value
basis points of price movement primarily focused on big-picture concerns, of its underlying assets. What’s more, a
halfway around the world can leave trying to stay abreast of constantly chang- marginally popular ETF can have less liq-
money on the table when it comes ing global financial markets. “They can’t uidity than its underlying shares, negating
to the way he manages his fund. But spot- take their eyes off the investment process the price advantage of buying the stocks as
ting a winning trade is one thing; putting it long enough to streamline and become a group. Going short on an ETF can add ad-
on in the most economical way is another. more efficient,” says Paul Zabaleta, the New ditional costs if the ETF wrapper is “hot”
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2. and the price of borrowing the ETF exceeds structures is to gain access to a market that be subject to transaction taxes that apply
the price of borrowing its components. is otherwise unavailable. Similarly, a mar- to stock sales, such as stamp duties, and
One solution, then, is to provide the eco- ket for a particular instrument might not may be used for long-range tax planning.
nomics of a long or short position in an in- yet exist in some emerging economies, leav- Other operational and financing costs
dex through a cheaper vehicle, such as a ing synthetics as the only avenue through can be reduced or minimized as well. For
swap. In a simple swap transaction, the buy- which to gain access. example, an investor who wants long or
er receives the gains and pays the losses in- Setting up trading accounts in many short exposure to the KOSPI must post a
curred by the same basket of stocks Asian countries, for example, “can be ad- 15 percent margin with the exchange. Not
represented by the ETF. The counterparty — ministratively cumbersome,” says Sylvie only might that require a substantial capital
Merrill Lynch, for example — takes the other Strauss, head of product development for commitment, but it might also require
side of the trade. Typically, no cash changes Merrill Lynch’s structured-product market- an investor to convert his currency into
hands at the outset, though the counterparty ing operation in Hong Kong. Many require Korean won and back once the transaction
may require the buyer to post margin. Price
movements are calculated on a notional
amount, and the position is periodically
marked to market. Merrill’s global negative
“SYNTHETICS offer the opportunity to
affirmation product eases the administrative
burden of trading swaps. “Why buy the ETF
INVEST GLOBALLY in a kind of one-stop-shop
when you can have a swap that gives you the
return of the stocks but doesn’t force you to
environment using a SINGLE CURRENCY.”
pay the management fee on the long side or
pay the sometimes expensive borrow when
the ETF goes hot?” Zabaleta asks.
Once an investor is comfortable with
the idea of achieving the economics of sec-
tor ownership through a swap, the doors
open to additional refinement. Depending outside investors to register and obtain for- is completed. But the same transaction
on the situation, ETFs can be efficient mo- eign-investor identification papers. China, can be accomplished without margin or
mentum trading tools or blunt instruments. for example, sets quotas on foreign capital. currency exchanges via a swap or through
An investor may be looking for more surgi- Such requirements may be too burden- a synthetic future on the index.
cal precision. Perhaps he or she likes nine some for a hedge fund desiring only short- A swap also works well in markets
stocks in an index but doesn’t want to hold term or sporadic access to the region. plagued by a lack of freely exchangeable
the tenth. The investor could buy the index Merrill, however, can offer access products currency. A synthetic structure can be
and short the unwanted stock. But a more by leveraging its presence in these markets priced in dollars for U.S. investors, for ex-
efficient play is to use a swap to gain long for the benefit of clients. It can provide ac- ample, avoiding local margin requirements.
exposure to only the nine stocks, creating cess to a single security or put together cus- Thus, synthetics offer the opportunity to in-
a customized index for less than the cost tomized baskets of securities and convey vest globally in a kind of one-stop-shop en-
of owning the exchange-traded index. A the economics of ownership via a swap or vironment using a single currency. “We can
customized index can be used for a variety a low-strike-price option. offer products across the globe that look
of purposes, such as to anticipate big moves Another popular access product is a and feel the same,” Strauss says.
in a sector. “We can create these customized synthetic short position, which replicates Through synthetics, clients are piggy-
indexes and list them on Bloomberg, where the economics of a short-sale transaction. backing onto the global footprint of Merrill
you can see them ticking live,” Zabaleta says. In markets where stock loan is not an al- Lynch, which can use its size and presence
Using a swap can be an ideal strategy for ternative, where appropriate, a firm such in markets throughout the world to gener-
a hedge fund that wants a low-friction way as Merrill can sell shares from its invento- ate economies of scale and pass them on to
to adjust exposure to a market. It can also ry to create a transaction that can be repli- clients. “You are basically outsourcing a lot
be a cost-saving device for a pension fund cated via a swap or a similar synthetic of the administration and complexity to us,”
that wants to deviate from its asset-alloca- structure. “Our bread and butter in Asia Guillemette says. For managers who already
tion strategy on a short-term basis without is providing both long and short access to have enough complexity to deal with in im-
incurring high transaction costs. For insti- clients in emerging markets,” says Eddie plementing their own investment strate-
tutional investors who aren’t permitted to Guillemette, of Merrill’s Asia-Pacific stock gies, that can be a winning tactic.
invest in over-the-counter securities, the loan group.
economics of the transaction can be struc- DAVID LANDIS is a financial writer in New
GETTING AN OPERATIONAL EDGE
tured in the form of a listed security — a York. He is a contributing editor at Kiplinger’s
warrant or an equity-linked note — that Because synthetic structures convey the Personal Finance and has written for Busi-
can be listed on an exchange, its price economics of ownership (though not voting nessWeek, the New York Times, the Wall
published on Bloomberg. rights) without any direct transaction in Street Journal Online and Financial Planning.
the underlying security, they can offer tax Previously, he was the news editor and person-
OPENING UP GLOBAL MARKETS advantages in jurisdictions outside the U.S. al finance editor at TheStreet.com and a
Another key rationale to using synthetic Swaps and other synthetics also may not reporter at USA Today.
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