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NA institutions view liquid equity derivatives as cash alternative

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A growing number of North American institutional investors are using listed and highly liquid equity derivatives for hedging and investing purposes.


This includes

A growing number of North American institutional investors are using listed and highly liquid equity derivatives for hedging and investing purposes.


This includes the practice of employing them as an alternative to “cash” equities in gaining exposure or taking positions, and as a means of minimizing equity trading costs. At the same time, institutional use of customized, structured, and hybrid derivative products is declining fast.


Greenwich Associates’ 2005 Equity Derivatives research study reveals 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.


However, the research also shows a considerable year-to-year fall-off in the use of structured products such as customized OTC, securitized, and hybrid derivatives. Declines in usage appear across a wide range of products, including single-stock or basket-based instruments, fund-linked or index-based products, variance swaps (which increasingly are viewed as flow products), and dispersion trades.


“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,” says Greenwich Associates consultant Jay Bennett.


ED “Flow” Products: The Cash Alternative


An increasing number of North American institutions are employing equity derivatives to implement a wide variety of investment strategies. For example, the proportion of institutions using single-stock listed/vanilla OTC options has risen from 68 per cent in 2003 to 76 per cent in 2005. Over the same period, the share of institutional investors using listed/vanilla OTC index options has risen from 59 per cent to 63per cent, and the proportion using index futures rose from 55 per cent to 58 per cent. Exchange-traded funds (ETFs), which were used by only 57 per cent 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,” says Greenwich Associates consultant John Colon.


Fellow consultant John Feng adds: “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.”


Declining enthusiasm for structured derivatives


In sharp contrast to the situation in flow equity derivatives, Greenwich Associates’ research demonstrates that the numbers and proportions of North American institutional investors using customized, structured, and hybrid derivative products is declining sharply.


In 2004, Greenwich interviewed 107 institutions identified as substantial users of equity derivatives. Half of these were using structured products such as customized OTC, securitized, and hybrid derivatives. This year, the firm interviewed 104 equity derivatives users and only 30per cent are using these structured products, with the remainder reporting use of flow equity derivatives only.


The slowdown in the US 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 them increased from 70 per cent in 2004 to 85 per cent 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,” explains Feng. “Less than 5 per cent of institutions in North America have adopted this practice.”


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