Derivatives 2006 - Volatility returns
For most equity derivatives dealers, 2006 will go down as a good year, in part because of the renewed volatility in equity markets. And among clients, dispersion trading strategies are proving to be money spinners. Hedge funds that spent the summer licking their wounds after the late spring volatility spike are again ready to focus on trading. Jean Haggerty reports.
The late May jump in equity volatility caught out many hedge funds and some dealers that were running short volatility positions. This reduced fund appetite to take risk significantly, resulting in a quiet summer.
A reduced risk appetite was also seen among real money accounts in the wake of the spring spike.
Since mid-June business in selling calls has shrunk because clients are too scared, dealers said, noting that for much of the summer these accounts were simply buying put spreads and collars.
One of the areas where dealers have reported the least reduction in risk appetite is in dispersion trading strategies. This is partly due to the resurgence in M&A activity and because of trading opportunities that could be built around company-specific stock performance.
Dispersion trading strategies typically involve short selling options on a stock index while at the same time buying options on the component stocks to create a short correlation and long dispersion position.
“In general, a lot of clients are pretty confused over the different signals that are coming out of the different regions and asset classes,” said Cyril Levy-Marchal, managing director and head of equity derivatives flow trading at JPMorgan in London. This, he noted, is causing many to hold cash.
“This downturn [during the spring] reminded everyone that the equity markets can go south,” said David Escoffier, head of equity derivatives at Societe Generale in London. Although equity markets remain positive, market sentiment is not as strong now as it was in March.
As a result [of this downturn] real money accounts, especially pension funds, have been very interested in the “Reverso” product, he said. Reverso is a derivatives strategy developed by SG that plays both the upside and the downside of global equity markets to optimise long term allocations to their equity buckets. The potential of the Reverso mechanism was highlighted in a recently published survey of Swiss Pension Funds made by St Gallen’s University business school.
Against this backdrop, some dealers are seeing an increase in market neutral strategies, such as reversals and Palladium-like trades and research driven long/short equity indices. Others are devoting more time to new underlyings or to accessing products that can help investors diversify their portfolios.
“[The move] away from exotic products on simple underlyings to simple derivatives on exotic underlyings is likely to continue…. Clients want exposure to new asset classes, not new packaging [of traditional asset risks],” said Donald Leitch, head of exotic equity derivatives structuring at Commerzbank corporate markets.
The trend towards new underlyings intersects with the move toward dealer-created, customised indices, which hit a new pitch last year. On both counts, dealers are creating an alternative to active management by systematising strategies - either by creating customised indices or by underpinning structured products with algorithmic trading strategies.
These trends are a reflection of the speed at which modelling technology is developing. The ability to copy payoffs is practically instant nowadays, prompting dealers to turn their focus away from payouts to new underlyings.
The push on new underlyings gives investors access to new assets where dealers can then propose systematic strategies. The development of customised indices is an extension of the move into alternative assets and hedge funds that gathered momentum in 2002, dealers say.
Dealer-created, customised indices, such as Deutsche Bank’s quantitatively-based CROCI index and Merrill Lynch’s fundamentally-driven Europe 1 index, have focused on equities, but more dealer research monetisation indices covering commodities, credit and cross-asset class underlyings are expected in the coming months. Although encapsulating asset classes other than equities, these products are typically viewed as part of equity derivatives product lineups. The term ‘equity derivatives’ has been a slight misnomer for some time. The range of products included under the heading has always been very large, and more often than not, the investment manager of the equity bucket of any given institution is the manager that gets the mandate for looking into new asset classes.
The market for structured products based on algorithmic trading strategies is deepening, and in Europe regulations including UCITS III and the European Markets in Financial Instruments Directive (MiFID) promise to usher in even greater use.
For equity derivatives dealers, MiFID, which takes effect in Europe next year, will require more oversight of their businesses and more paper work. However, equity derivatives dealers did manage to convince regulators to accept back testing for investment products. Regulators, notably the UK Financial Service Authority, have long noted that past performance can be misleading.
While this can be true, back testing is often the best way to show the potential performance of an investment product, Escoffier said. Under MiFID, dealers who want to show potential clients an investment product’s back testing results must go back as long as possible and show the product’s average low and maximum returns to ensure that a fair representation of what can be expected from the product is made.
Having a common way to show clients what to expect from products will be helpful.
“The issue is for retail investors. You want to make sure that they fully understand the product. One of the biggest risks [facing the structured product market] is mis-sold products,” Escoffier noted.
The European mutual fund directive, UCITS III, which took effect a year ago, enables dealers to package algorithmic trading strategies into UCITS III funds. Dresdner Kleinwort and its private banking arm, Kleinwort Benson, last month became the first dealer to take this route when it added algorithmic trading-driven equity volatility funds to the Gresham Defined Funds platform, a UCITS III-compliant vehicle.
Dresdner Kleinwort’s new funds, the DEVA 80 & 90 Alpha funds, were designed to use an algorithmic strategy to take advantage of differences between implied and realised volatility in the US equity market using the S&P 500 index. In both funds, the underlying asset is equity volatility, which as an asset is not accessible to many market players. Additionally, the funds’ use of a dynamic trading strategy means there is no reliance on a fund manager.
Investors are warming to the concept of algorithmic-based products because they have seen that these products have had very consistent performance, are disciplined in their approach and risk management, and have a higher probability of repeatability than more traditional approaches, said James Norman, global head of product management within Deutsche Asset Management’s quantitative strategies group in New York, when his firm announced its new algorithmic-based product last month.
JPMorgan has also recently launched additions to its algorithmic-driven investment product line-up. Its new product, dubbed Yield Alpha, is a non-discretionary, algorithmic-driven strategy designed to act as an alternative to standard money-market or cash investments. Yield Alpha replicates bond, equity, volatility and foreign exchange carry strategies overlaid on a cash investment. The strategy is offered through delta-1 certificates, leveraged certificates, principal-protected notes and in UCITS III fund form.
For the algorithmic-driven structured products’ target audience - retail and high-net-worth clients - the end result is a product that promises diversification through investment in an asset that is uncorrelated to traditional assets, dealers say, pointing out that alternative asset diversification was one of the original appeals of hedge fund investing.
Institutional investors, such as pension funds and insurance companies, clearly need and want to diversify. While they are moving to other asset classes, like hedge funds, they also do not want to reduce their exposure to equity markets, particularly if there is a fair chance that equity markets will perform well.
Pure volatility instruments, such as volatility swaps and variance swaps, can make sense for institutional investors because volatility is both a diversifier on the downside and a global hedge on an equity portfolio.
Institutional investors are starting to become aware of their exposure to equity volatility and have become more active users of equity volatility as an asset class. “It is still early days and we are not sure if it will take off as an asset class for quite sometime,” said Fred Clatworthy, managing director in equity derivatives at Nomura International in London.
According to some dealers, this is mostly to do with the fact that the process to adopt a new asset class and different trading styles can be lengthy. The interbank variance swap market itself is substantial and constantly getting bigger, they add. “Gone are the days when you buy straddles. You just buy variance now,” Clatworthy noted. Options on variance swaps are also starting to trade with greater regularity in the interdealer market.