A growing portion of North American institutional investors are using listed and highly liquid equity derivatives for hedging and investing purposes, in some cases employing them as an alternative to “cash” equities, a US-based research firm found.
“Our research provides some invaluable insights into how institutions are employing equity derivatives – or in some cases ceasing to use them – in order to get exposure more efficiently, more anonymously, with better tax advantage and greater leverage,” said Jay Bennett, consultant at Greenwich Associates, the firm that headed the survey.
The study revealed that a sizable number of North American institutions this year experimented for the first time with equity derivative “flow” products including single-stock listed/vanilla OTC options, listed/vanilla OTC index options, index futures, exchange traded funds, single-stock futures and equity swaps.
The proportion of institutions using single-stock listed/vanilla OTC options has risen from 68% in 2003 to 76% in 2005. Over the same period, the share of institutional investors using listed/vanilla OTC index options has risen from 59% to 63%, and the proportion using index futures rose from 55% to 58%. Exchange-traded funds (ETFs), which were used by only 57% of institutions in 2003, are now used by two-thirds.
“The rising employment of equity derivatives in such strategies as actively managed long-only equity, passive equity index, and simple price speculation, suggests that a rising number of institutions are using equity derivative instruments as substitutes for ‘cash’ equity trading,” said John Colon, a Greenwich Associates consultant.
“From the standpoint of these equity professionals, equity derivatives offer two other benefits: anonymity and leverage – although the amount of the latter obviously varies from institution to institution and from broker to broker,” said John Feng a consultant at Greenwich Associates.
The research also found a considerable year-to-year fall-off in the use of structured products such as customized OTC, securitized, and hybrid derivatives. Contrasting the situation in flow equity derivatives, the report found that that the numbers and proportions of North American institutional investors using customized, structured, and hybrid derivative products is declining sharply.
Greenwich interviewed 107 institutions identified as substantial users of equity derivatives in 2004. Half of these were using structured products such as customized OTC, securitized, and hybrid derivatives. In 2005, the firm interviewed 104 equity derivatives users and only 30% are using these structured products, with the remainder reporting use of flow equity derivatives only.
The firm suggests the slowdown in the U.S. stands in stark contrast to the situation in Europe. While North American institutions are cutting back on their use of customized OTC, securitized, and hybrid derivatives, their counterparts in Europe have greatly expanded their presence in structured products. The proportion of European institutions using customized OTC, securitized, and hybrid derivatives increased from 70% in 2004 to 85% this year.
“The fundamental difference between the European and US markets is that, in Europe, institutions are on-selling these structured equity derivative products to high-net-worth and other retail clients, while less than 5% of institutions in North America have adopted this practice,” Feng said.