Towards liquidity and transparency: Entering a new world

Derivatives have been variously criticised, derided and condemned from all quarters over the past several months, and much of it has been misdirected. But equity derivatives have flown through the worst of the flack largely unscathed and, even better, they are considered to offer a range of solutions to two of the most pressing concerns of embattled investors - liquidity and transparency.
Chief among the potential solutions to the new market paradigm are managed accounts and exchange traded funds (ETFs). Neither product is new, but both are experiencing a strong upsurge in interest and a sizeable inflow of funds.
Managed accounts
Many hedge funds last year found themselves saddled with positions in illiquid assets, at the same time as markets were collapsing and investors were seeking mass redemptions. Unable to sell assets fast enough to meet client requests, several hedge funds were obliged to suspend redemptions or impose lock-ins to slow down the rate of attrition. As if this were not enough to undermine investor confidence, the Madoff fund scandal then erupted. The result has been a concerted move away from direct hedge fund investments to managed accounts.
Aurélie Vincent, head of commodity trading advisors, foreign exchange and global macro strategies at Lyxor, believes 2008/09 will prove to be a seminal period for the managed account industry. "Following Madoff, the sudden imposition of investment gates and the growing liquidity and transparency concerns, more and more investors have begun to turn to managed accounts," she says.
The shift to managed account investment makes sense on several levels. A significant number of investors still believe that hedge funds represent good investment opportunities, but wish to protect against operational and liquidity risks, including gating and fraud. The managed account is the best means that they have found of doing so.
Managed accounts have more control over the assets they deposit with hedge funds, requiring that each manager runs segregated accounts instead of parking the assets in their main fund. In addition, portfolio valuations are carried out by the platform manager, thereby ensuring the independent accuracy of the performance reports, and risk management controls are put in place to ensure that hedge funds do not drift away from their stated strategy or take on too much risk. Finally, the platform managers make - and are able to fulfil - liquidity pledges to their clients.
A lot of the protections that were built into managed account processes were developed by banks wishing to offer exposure to hedge funds through structured products. And it is those same standards of transparency, liquidity and reporting that they required then, that are being sought by investors today.
To the fore
Martin Fothergill, head of the managed account platform at Deutsche Bank, says: "All of the events of last year have conduced to putting the managed account structure at the forefront of investing. We are being approached now by all sorts of clients who are looking to move their investments into managed accounts - including the really large, well-staffed and well-resourced family offices and funds of hedge funds who previously refused to consider managed accounts."
According to Ms Vincent, it is not only investors that have made the shift in mindset, but hedge funds themselves. As fund managers have found that a growing proportion of their clients are now reluctant to invest directly in their funds and show their preference to invest through managed account programmes, they have become willing to subject themselves to the scrutiny of managed account platforms. "Some of the best-known and largest managers [who] previously refused to consider managed account programmes are now approaching Lyxor directly as, by submitting to the scrutiny the firm imposes, they can demonstrate to investors that they are sufficiently transparent," she says.
Mr Fothergill agrees: "Hedge fund managers are much more interested to work with us today, in good part because an increasing number of investors are seeking to invest only through the managed account route."
In a response to the increased interest in managed account products from institutional investors, Lyxor is building so-called dedicated managed platforms for individual clients. Typically, the investors will approach Lyxor with a pre-determined list of hedge funds in which they wish to invest; Lyxor will then create a tailor-made investment platform around these parameters.
If hedge fund 'gates' and Madoff can be deemed responsible for the growth being experienced by the managed account industry, it is the relatively poor performance of active managers and the uncertain market outlook that are driving assets into the ETF industry. Much as ETFs benefited from the bursting of the 'tech bubble', so trackers are gaining traction again; ETFs raised a whopping $270bn in total last year.
Isabelle Bourcier, head of sales for listed products at Lyxor, says: "It has been a great year for all the players in the industry - there is a strong need for simplicity, transparency and liquidity which are the main features of ETFs."
Manooj Mistry, UK head of DB X-trackers at Deutsche Bank, adds: "Over the past 12 to 19 months there has been lots of volatility and significant shifts in investment behaviour, but within all of this, ETFs have been among the largest net beneficiaries. ETFs tick all the right boxes - they are liquid, transparent, regulated and low-cost vehicles."
Ted Hood, chief executive of Source, a newcomer to the ETF industry, believes that an additional appeal has been that ETFs can potentially involve much less counterparty credit risk and are considerably less operationally intensive than the alternatives within the index spectrum - such as swaps and warrants.
According to Ms Bourcier, demand for ETFs first really picked up following the Lehman collapse and initially came mainly from traditional long-only managers who were seeking ways to remain invested, did not want to invest in single stocks and wanted quick access to cash. And although there are no statistics as yet to uphold these claims, it appears that the initial influx experienced last year has continued.
Mr Mistry says the driver has been the wholesale take-up of ETFs by institutional investors who are using the instruments systematically as part of their long-term asset allocation strategies, as well as for tactical investment purposes. Somewhat more surprising is that corporates have also begun to use the instruments. "Corporate treasurers have been using our money market ETF - the Eonia ETF - as an alternative to putting cash on deposit and as a means of minimising counterparty credit risk," he says.
Significant appeal
Ms Bourcier also reports that more and more private bank clients have been turning to ETFs, in search of lower fees and due to the switch by private banks, as a result of regulatory pressure, from the retrocession method to fee-based models. "At the same time, we have seen a strong move into ETFs from pension funds seeking short-term broad-based market exposure, particularly from northern European and UK pension funds which have been using ETFs to gain exposure to emerging markets," she adds.
Inevitably, perhaps, the growing clout of the ETF industry has attracted newcomers to the business. Chief among these is Source, an open architecture platform created by Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley. The platform debuted in April this year, with the launch of 13 ETFs and a further two exchange traded commodity products.
The Source founders believe that there is scope for them not just to enter this relatively mature market but also to make their mark. This, they believe, can be achieved by enhancing the performance and trading environment for ETFs in Europe, by creating common standards and better design features, offering investors improved liquidity, reduced credit risk, increased transparency and more efficient competition.
Mr Hood believes Source's main opportunity lies in addressing the thorny issue of liquidity. In the US, daily liquidity in ETFs exceeds $90bn, or 17% of ETF assets under management, while in Europe that figure is approximately $2bn (less than 2% of ETF assets under management). Source is seeking to drive up the liquidity and encourage people to trade ETFs in two different ways.
First, it will undertake 'create-to-lend' programmes, similar to those implemented in the US. Capitalising on the hedge fund relationships of its backers and their established stock-lending capabilities, Source is seeking to create a deep and vibrant lending market for the ETFs. Mr Hood claims that this will allow investors to earn incremental revenues as well as stimulating trading activity.
Second, each Source product will be listed on only one exchange. "When products are listed on multiple exchanges it can become very confusing," says Mr Hood. "Different sizes and prices will be quoted on the different exchanges, and if an investor asks a liquidity provider for a price or looks at the exchange prices, he is likely to get different prices. By listing each of our products on only one exchange we consolidate the sources of prices for our products, at the same time as concentrating capital and liquidity. It should therefore make ETFs much easier for investors to access, as well as simpler to manage for the liquidity providers who only have limited capital to put up."
And Mr Hood also believes that having multiple committed liquidity providers behind Source, rather than the traditional single backer, and quoting prices both on and off exchange, will give Source an additional edge. "You must not forget that we are also very robust from a credit perspective," he adds. "What is unique about our funds is that each fund will trade with a number of counterparties; this both diversifies the counterparty risk and separates the manager from the sponsoring banks. This latter point is very important because it really means that the amount of money at risk is very small in real terms."
Evolutionary thrust
Equity derivatives groups would not be equity derivatives groups if they did not come up with something new in response to a market change - and here they do not disappoint. And, although its impact may be diminutive compared with that of managed accounts and ETFs, one of the latest inventions deserves a mention. The American Variance Swap is a semi-exotic product that is essentially a US option-style variance swap. In other words, it is a variance swap that can be exercised at any time at will, rather than only at maturity.
Stéphane Mattatia, Société Générale's head of engineering for hedge fund business, says: "The product gets around the wide bid offer spreads in the variance swap market today by giving the investor the right to exercise at will, at realised volatility - as opposed to being able to exercise the swap, taking into account both realised and implied volatility."
This product was developed by SocGen in response to the fact that, although many of the exotic products that hedge funds were trading before the crisis erupted behaved very well, the managers had since re-directed their investment strategies towards more vanilla, liquid and transparent products. In that sense the American Variance Swap is the perfect hybrid - an essentially simpler, cheaper version of an already popular trading product.