Investment Managers Beginning To Employ Equity Derivative Products
The derivatives markets have always been shrouded in mystique. They have been the playground of rocket scientists, speculators and opportunists, where fortunes are made -- or lost -- in the blink of an eye. Through this shroud, investors rarely fit the profile of Joe and Jane Everyman, but rather of the jet-setting, high-rolling, wealthy risk-taker.
Unfortunately, this characterization has become self-fulfilling as traditional mutual funds and asset managers have shied away from the complexity and risk of derivatives -- some by choice and others by charter. The emergence of hedge fund managers over the past 10 years only reinforced this view, as derivatives were seen as the domain of specialized investment professionals.
But the world of investment management is changing. Absolute return strategies, portable alpha, hedge funds and yield enhancement are all becoming part of the everyday life of a traditional portfolio manager. Traditional long-only funds are gaining leverage through 120/20 and 130/30 vehicles, and derivatives are becoming strategic tools of choice for today's more-sophisticated portfolio managers.
Why Derivatives, Why Now?
Investment managers by nature are conservative. They typically manage money for pensions, retirement plans and unsophisticated investors. They have a fiduciary responsibility not to take risk. So why are traditional investment managers beginning to employ equity derivative products?
The answer is options. Not the options that one buys at the exchange, but options as in the number of tools the money managers have in their utility belts. Typical long-only managers have only one tool in their belt -- they can buy appreciating securities and liquidate them once they believe the security will no longer perform as desired. Going only long handicaps portfolio managers when they believe a permanent or even a temporal event will either positively or negatively impact a security's or sector's market value.
Derivatives change this value proposition. They enable portfolio managers to utilize market value changes that are not able to be captured through traditional long-only methods, acquire exposure to broad indices and generate revenue on less-volatile long-term positions. Derivatives also enable portfolio managers to hedge their risks when selling large portions of the portfolio that are not tax-efficient or realistic.
Adding to the demand is the constant search for alpha. Investors are searching for greater and more-diversified returns as they look toward absolute returns rather than benchmarked ones. Fiduciaries also see significant gaps between pension fund assets and liabilities, and are examining tools to close these shortfalls.
All these trends point toward an increased use of leverage, the wider use of derivative products, and the exploitation of investment strategies that enable portfolios to appreciate in ways traditional buy and hold strategies cannot.
The Need for Technology
Despite the pervasive use of technology throughout the securities industry, the complexity of pricing and trading derivatives, and the volume of exchange-traded derivatives market data, there is a remarkable lack of integration among technological tools on the buy-side derivatives trading desk. As a result, derivatives trading remains a manual process with the phone and disconnected tools providing the framework for the trading processes. Electronic trading via direct market access and FIX communications does exist but has just started to be implemented, with systems just beginning to be adapted to meet the intricate needs of derivatives.
The increased use of these technologies will foster expanded use of electronic trading and its strategic capabilities as electronic connectivity among market participants becomes the norm. Algo trading in the derivatives markets is still in its infancy, but all the components for its rapid development are there: electronic liquidity, broad market participation and interconnected markets.
The experience of the equity markets will provide a road map for the transformation of the derivatives markets from high-touch voice-brokered transactions to low-touch technology-enhanced transactions. Just as technology enabled algorithmic trading in the cash markets, so too will it evolve in the equity derivatives market.
Broker Relationships Are Still Critical
Much has been written about the loosening of ties between the buy side and sell side. Automation and concurrent electronification of the financial markets both have contributed to this change. Order control has empowered buy-side traders to trade more proactively.
But this empowerment has not progressed evenly across all financial marketplaces. Highly homogenized markets such as cash equity markets with deep liquidity pools have been transformed into a giant network of interconnected markets, with public and private liquidity pools intermingled through electronic systems that instantaneously route orders to best markets.
However, markets lacking deep liquidity have not transformed as quickly, nor have they adopted buy-side-oriented advanced trading solutions as fast as more-liquid markets. In these "trade by appointment" markets, relationships among counterparties are critically important, with little activity occurring without dealer intervention.
Equity derivative market structure fits both molds. Liquid, exchange-traded markets with both size and volume do exist but are mainly concentrated in near months with strike prices closely correlated to the market. Derivatives with distant maturities or that are deep in the money see limited trading activity and suffer from wide spreads and limited available size. These markets rarely have large trading volumes.
For these thinly traded markets, dealers are central in making markets, providing liquidity, providing market color and offering research. Buy-side derivatives traders and money managers work together with dealers as strategists and partners in the creation and trading of derivative instruments. The complexity of trades, need for capital and demand for strategic advice all contribute to the close working relationship that develops between specialized derivatives dealers and their buy-side trading customers.
What the Future Holds
Although exchange-traded derivatives usage is expanding, we are still in the beginning stages of its institutionalization. As traditional funds expand their leverage, new product developments facilitate risk transfer, and traditional long-only managers begin to see both the benefits as well as understand their risk, derivatives will become a key tool for increasing returns, managing risk, and gaining exposure to markets and returns that are unable to be actualized in any other way.
Derivatives have become an important tool that will increasingly be used by a broad range of investment managers seeking to both minimize risk and maximize alpha. Traditional asset managers will increase their usage of derivatives for risk management and increased opportunity for alpha. Hedge fund managers have deployed futures and options as primary high-return strategies, while other managers integrate derivatives into their portfolios to balance and offset the growing risks that accompany their goal of exceptional returns.
--Andy Nybo is a senior analyst with TABB Group. He has more than 20 years experience in marketing, research and technology applications. Most recently, Nybo was head of marketing and communications at MarketAxess. Prior to his tenure at MarketAxess, Nybo was a senior analyst at TowerGroup, where he focused on electronic trading, OMSs and STP initiatives in the fixed-income markets. Prior to TowerGroup, Nybo was VP and director of research at The Bond Market Association
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