Exchange-Traded Equity Derivatives Set to Skyrocket as Absolute-Return Strategies

Date: Wednesday, April 11, 2007
Author: RiskCenter Staff

The world of investment management is changing with absolute-return strategies, portable alpha, hedge funds and yield enhancement an integral part of the everyday life of traditional portfolio management. According to TABB Group in its newest benchmark industry study, “Exchange-Traded Equity Derivatives: The Buy-side’s Increasing Exposure,” these changes are creating a seismic shift not only in the way exchange-traded equity derivatives – futures and options – are used but also in who trades them and how they are traded.

“As an increasing number of traditional fund managers migrate from long-only to 120/20 and 130/30 portfolios and become more adept at managing risk, employing absolute return strategies and extending leverage,” writes Andy Nybo, senior analyst at TABB Group and author of the study, “derivatives will become a more important part of traditional investment strategies. As this evolution occurs, institutional investors will have a greater need for a host of tools and services designed for the intricacies of the derivatives market.” He adds that, “as analytics, risk management and the greater use of specialized OTC derivatives become integrated into traditional equity-driven investment and trading tools, derivatives will become even more integral to manager strategies.”

Increased use of technology, specifically leveraging electronic connectivity, will be a prime driver of future change in this global asset class. “Although algorithmic trading in the derivatives markets is still in its infancy,” explains Nybo, “all of the components for its rapid development are present, including electronic liquidity, broad market participation and interconnected markets.”

“The equity derivatives markets are on the cusp of transformation,” adds Larry Tabb, CEO and TABB Group founder. “They are becoming more ‘socially’ acceptable to the conservative long-only asset manager and, perhaps more importantly, to oversight boards that dictate policies and procedures. Long-only funds compete for AUM with less-restricted hedge funds that are aggressively using derivatives to enhance returns. This is forcing traditional asset managers to embrace equity derivatives as a means of both increasing and preserving returns. The best fund managers will continue to embrace derivatives for risk management, capital preservation and the ability to aggressively seek alpha opportunities.” However, adding a cautionary note, he says, “those managers that don’t will simply fall behind.”

Key findings include:

Hedging is the dominant use of derivatives by over 40% of the traders interviewed, followed by equitizing (31%) and capturing trends (29%).
Over 50% of the traders say that liquidity is the greatest challenge in trading options. Although penny pricing is expected to improve liquidity, they expect liquidity will become more fragmented, spreads will tighten and liquidity at each price point will decline.
Despite the importance of phone-based trading, futures traders are dissatisfied with the electronic tools and DMA systems they have access to, saying they would benefit from advanced order routing and execution capabilities.
Less than 20% currently use FIX in derivatives activities.
Generating premium income from writing covered calls was a strategy used by 92% of the options traders.
Nine out of ten say obtaining the right price on trades is far more important than execution speed.
Traders have relationships with an average of five brokers vs. over 50 for cash equities.

The 54-page study with 50 exhibits is based on in-depth interviews with 55 different buy-side futures and options traders based at a broad variety of asset managers and hedge fund. Participants are segmented by assets under management (AUM) and where appropriate by type of equity derivative employed. The study categorizes asset managers and hedge funds into three different AUM categories, e.g., asset managers were segmented as large (over $50 billion); medium ($10 billion and $50 billion); and small (less than $10 billion). Hedge funds were broken into the same categories but included large (over $1 billion); medium (between $100 million and $1 billion); and small (less than $100 million).

The study is available for download by TABB Group Research Alliance clients and qualified media. To view an executive summary or to purchase the report, visit http://www.tabbgroup.com/research.