Tailor-made for a burgeoning market
Instruments designed specifically to hedge ETF exposure will allow for more precise trading and more comprehensive investment strategies.
Exchange-traded funds (ETFs) are relative newcomers to Europe. The market here began when Deutsche Börse launched its XTF segment in April 2000. Although still in its infancy, the European ETF market has grown rapidly in popularity. Another significant development for the European ETF market will occur on November 18, 2002, when Deutsche Börse’s Eurex launches ETF futures and options. State Street Global Advisors created the first ever ETF, an S&P 500 tracker now known as the “Spider”, only as recently as 1993. The fund currently has a market capitalisation of around E36bn and is one of the most actively traded securities in the world. Encouragingly for European ETFs, growth here has been far faster than that initially seen in the US. Easy access ETFs have become popular because they combine the flexibility and tradeability of individual shares with the risk diversification features of funds. Units are easily created or redeemed when the ETF fund managers exchange them for the underlying securities. Effectively, this means there is no ceiling on the ultimate size of the fund and access in and out is as easy, if not easier, than selling individual equities. There are now more than 150 ETFs available in Europe, including domestic, pan-European and global funds. Deutsche Börse accounts for almost half of the overall European investment volume of around E10bn. Growth has been impressive, yet market commentators still talk of European ETFs as products that have yet to reach their full potential. The new futures and options contracts being launched by Eurex will provide more discrete risk management tools for all investors. There is an increasing need for tailor-made hedging instruments that fully match the characteristics of ETFs. Other investors are also keen to decrease or increase their exposure to specific sectors. Expansion ETF futures and options are ideal tools to meet both requirements. International trading firms will support the new products by acting as market makers. This will ensure that there is ample liquidity and tight bid/offer spreads right from the very start. The range of equity and index products currently available were not designed specifically to hedge ETF exposure. The new products will do this. And because of their relatively small contract value, they will allow all investors to implement more precise trading or hedging strategies. The whole market should now be able to rapidly gain or reduce risk, an essential requirement for many, given the current volatile market conditions. For professionals, ETF futures and options will expand the arbitrage and trading opportunities that already exist. For fund managers, they will help neutralise tracking errors. The price of an ETF is not perfectly correlated with the corresponding reference index, mainly because of the timing of dividend flows. Typically, an ETF will trade at a premium to the underlying index for much of the time. Once dividends are distributed, ETFs revert back to the index level. This presents opportunities for basis traders and other arbitrageurs, while fund managers take various measures to compensate for this tracking error. ETF futures and options will appeal, for different reasons, to both groups. Options Just as the existing underlying ETFs have shown that they are not just the preserve of one particular market segment, it can be assumed that ETF futures and options will have a similar broad appeal. Their users will easily be able to decrease or increase their risk, whether of entire portfolios or more discrete geographic, industrial or cyclical sectors, or even combinations of all three. The availability of options will allow the construction of precise and sophisticated time and/or event sensitive strategies. Significantly, ETF futures and options will differ from existing index derivatives because they will be physically settled, just like individual equity options. This means that when they expire, the underlying ETF, rather than a cash difference between the entry and exit levels, will change hands. This increases their attractiveness for those many market participants who actually wish to invest in the respective funds or liquidate existing positions at the expiration of the contracts. The location of where the new ETF futures and options contracts are listed is important. By making them available on a global electronic derivatives exchange, investors will have easy and inexpensive access.
