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Derivatives take larger role with hedge funds

Surging flows of capital into hedge funds over the past few years have aroused fears that overcrowding in popular strategies will drive returns down and reduce the appeal of alternative investment approaches. However, the growth of sophisticated investment techniques involving the use of exchangetraded derivatives, with their high levels of liquidity and transparency, is offering managers and investors new opportunities to achieve higher returns, resulting in increased usage of futures and options worldwide.
The development is closely tied to the surge in popularity of so-called portable alpha strategies, in which managers - initially alternative but now increasingly traditional as well - use derivatives as a cheap and efficient means to gain exposure to the broad market, freeing up a larger proportion of the fund's capital to generate abovebenchmark returns through deployment of the manager's investment skills. Capacity issues affecting popular hedge fund strategies have grown in prominence in recent years, as the patchy performance of traditional asset classes has prompted an ever-wider range of investors to increase their allocation to alternatives. Estimates of the overall size of the hedge fund industry have recently risen to as much as USD1.5trn in assets spread across more than 10,000 funds.

This growth has seen the volume of assets invested in managed futures strategies nearly triple to USD145bn over the past three years, while other strategies that use derivatives, such as global macro and fixed income arbitrage, have regained their appeal among managers and investors. These trends have sharply increased the share of hedge funds in the global volume of exchange-traded derivatives transactions. Increased use of derivatives is linked at least in part to greater competition and lower costs. In the world's largest market, the United States, the leading derivatives exchanges have responded to the technological lead of their European rivals such as Eurex and Euronext.liffe to move from the traditional trading floor to screenbased trading, cutting costs and improving efficiency.

Exchange-traded derivatives are also seeing increased demand from European hedge fund investors because the continent's alternative investment industry continues to grow faster than the more mature US sector, more than tripling its volume of assets over the past three years to more than USD280bn. Growth has been strongest in credit-related strategies, prompting Eurex to work on its first credit derivatives futures contract. Equity index derivatives remain a key area of activity, given the continued predominance of long/short equity strategies among hedge fund managers in Europe and beyond. The options available to equity hedge managers have also been increased through the introduction of volatility futures at Eurex including the Dow Jones EURO STOXX 50, the Swiss SMI and Germany's DAX, which offer volatility hedging for classic equity strategies as well as underpinning the growth of volatility arbitrage funds.

But currently attention is focused on the use of futures as the basis for portable alpha strategies, by replicating exposure to equity and bond markets at merely the cost of margin requirements, enabling the excess capital to be invested in alpha-generating investments. The fact that this technique is available to both long-only and hedge fund managers is another development in the blurring of boundaries between traditional and alternative asset classes.

By Stefan Engels - a member of the institutional investor sales team at Eurex

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