Derivatives: old tips, new tricks
From exotic to the norm The march of derivative usage from niche strategies into mainstream asset management now seems inexorable. With the convergence between the absolute return focused hedge fund community and the mainstream asset management market, this increase in derivative use is mirrored by a growing sophistication in the markets that they serve.
Open to retail The introduction of the Ucits III rules in Europe has meant that ways of capturing alpha that were previously only available to an institutional audience are now available to a retail audience. Managers are moving quickly to try and adopt the new powers granted to them. Derivative instruments are viewed as pivotal to capturing greater outperformance and accessing new investment trends. In fact, many portfolio managers now claim that they could not achieve the expected returns that they do without using some form of derivative. The most visible trend post-Ucits III has been the emergence of so-called 130/30 funds, which use limited shorting and leverage to boost returns over equity market benchmarks. These funds attempt to deliver better returns by using total return swaps to mimic the physical shorts and gearing that hedge funds often use in their long/short equity strategies. However, unlike hedge funds, they offer the transparency of traditional long only fund management. A number of funds have been launched and investment managers have approached this opportunity from two distinct routes. First, established asset managers with depth of experience in managing alternative investments have de-leveraged existing products. Second, investment boutiques without experience have upgraded their abilities to reach this wider potential audience. However, derivatives are not just for the headline-grabbing equity strategies – they are being used throughout portfolios to better manage the balance between risk and return, and to minimise unrewarded risk. These unwanted risks can be as straightforward as unwanted currency risk through to the complexities of interest rate and inflation risk to which pension funds are subject. Another important market development is that the use of overlay strategies has now become mainstream. Overlay is often thought of as a refinement of the process through which managers can express their views in a conviction portfolio, with the resulting returns spread across the total portfolio performance. This means that investors with a relatively conservative outlook can seek more aggressive returns from their portfolios than were previously available. Getting the benefit While there are risks associated with trading derivatives (eg, counterparty, liquidity and basis), we believe that, when used appropriately, they can provide significant benefits to portfolio management. Specifically, they provide: greater flexibility to implement investment views across many markets; access to new investment opportunities; more precise risk management; cost efficiency; high liquidity; and optimal use of capital. However, we need to keep an eye on the practicalities of implementing these views. You should ensure that you choose a manager who is supported by a platform which has the operational expertise to process, value and report derivative transactions. Furthermore, you should look for a manager with risk management skills that are second to none to ensure that the derivatives’ effect on the overall risk chracteristics of your portfolio as well as counterparty risk are carefully monitored. As trading volumes in derivatives grow, managers who do not have sufficient support to implement and manage their trading strategies will swiftly find themselves left behind in the race to capture alpha.
