Exchange traded derivatives in hedge fund management

Volumes on the world’s futures and options exchanges would appear to be slowing down, given that across the board the percentage increase in volume is in the low, single digits!  However, when one digs deeper, it is apparent that some major products continue to see 15-20% volume increase, if not more.  What is driving this volume increase and should the market expect to see continued development?

At the annual Futures Industry Association in November 2005, Richard Berliand, Global Head of Futures and Options at JP Morgan, suggested that global exchange traded derivatives volume will increase almost 100-fold over the next 25 years!

Perhaps even more tellingly, Matt Andresen, President of Execution Services at Citadel, one of the world’s largest hedge fund groups, agreed with him: His view was that the growth of electronic trading in the absence of capacity constraints in the exchange traded derivatives market would contribute towards even greater volume.

At a time when there are question marks over the ability of the hedge fund industry to continue to deliver double digit returns on a continuous basis, with capacity constraints being cited as a potential hurdle to achieve such returns, it is worth investigating the relationship between these two dynamic industries further.

The last couple of years in the United States have been marked by the shift in exchange traded derivatives from the traditional floor environment onto screen.  This has partly been driven by the attempts of Eurex and Euronext.liffe to challenge the CBOT and CME franchises in Treasury and Eurodollar futures respectively (and more recently a move by Eurex into the FX futures arena).

This led to more than a 70% transaction fee reduction in Treasury futures for end customers at the CBOT (although there has been a subsequent 50% increase) and more recently the introduction of significant fee rebates for hedge funds, with given amounts of assets under management, in the CME’s FX contracts.  This reduction in cost and the improved electronic distribution of these products has resulted in vastly increased volumes.  So, has this volume been created by the traditional users of futures contracts or can this be attributed more directly to specific users?

These changes have come at a time when the assets under management in the hedge fund industry have increased to a reported USD 1 trillion assets under management.  Within the managed futures area specifically assets have increased over the last three years from USD 50 billion to USD 130 billion and hedge fund strategies such as global macro and fixed income arbitrage, which tend to be closely associated with futures and options contract usage, have come back into vogue.  Therefore, linking the increase in volume on-exchange with the developments in the hedge fund industry is appropriate.

Indeed, Berliand from JP Morgan is on record as suggesting that hedge funds have taken a greater interest in the futures markets as the level of liquidity and transparency has improved with the move to screen trading.  Moreover, as the returns for certain hedge fund strategies have reduced, as more money and competition has come into the sector, hedge funds are looking more closely at their cost base and demanding direct market access (DMA) to enable their own execution and/or lower commissions.  This has also led to the situation where some hedge funds have become direct members of exchanges as the barriers to entry have reduced substantially.  

Taking managed futures as an example it is possible to quantify some ballpark numbers on what number of contracts could be generated.  Given that an average turnover of 2,500 round trips per USD 1 million under management is not uncommon for managed futures, an increase of USD 80 billion under management would suggest an increase of 200 million round trips!

There is a general view that the split in terms of contracts traded under these systems is distributed 80:20 in favour of financial instruments to commodities.  This would suggest that 160 million financial futures round trips would have been generated versus 40 million commodity futures round trips.  This also reflects the level of liquidity that is available between the different sectors, with only some of the energy contracts having comparable liquidity to the flagship contracts in the financial sector such as Treasuries or Bunds.

Meanwhile, Foreign Exchange trading, which can account for 20-25% of the allocation of some of the larger CTAs, is not necessarily transacted on exchange, instead transacted via spot FX portals such as Currenex or FXAll.  However, some of this does come back into the organized futures market via related Exchange for Physicals and some of the smaller CTAs are happy to use the central order books.

This could reduce the potential number of round trips on the financial side by up to 40 million round trips, however that still leaves 120 million new round trips (and the related volume spin off from there) that this increase in assets under management could potentially have generated!

Looking more broadly at the hedge fund industry, but within Europe specifically, the entire assets under management have grown at a faster rate over the last 3 years than the more mature US market.

There was circa USD 85 billion under management with European managers which has now increased to more than USD 280 billion.  While the rate of growth has slowed to circa 10% last year there are certain strategies that have benefited more than others, whereas the largest increase appears to be in credit related strategies.  In that sense Eurex is already looking to satisfy some of the demand in this area by launching the first credit derivative futures contract in 2006.

In addition, some of the largest individual funds launched last year, such as SemperMacro, have been in the Fixed Income/Global Macro area which has also benefited Eurex in terms of their flagship fixed income contracts in particular.  In response to this increase in business Eurex has looked to increase the education and visibility of where hedge funds and exchange traded derivatives interact by commissioning independent research papers with academic groups such as the Centre for International Securities and Derivatives Markets in the US, the French business school EDHEC and Harry Kat at Cass Business School in London.

A number of new hedge funds are either a spin-out from an investment bank’s proprietary trading desk or where former senior proprietary traders from such firms have formed their own entity.  The majority of such traders have been used to trading against flow orders in the cash/OTC market and then laying off risk into the exchange traded market so they are very comfortable with expressing their exposure purely via the derivatives market, which is another boon for exchange volumes.

Long/short equity managers still maintain the lion’s share of assets under management both in Europe and globally .  Again Eurex benefits greatly from their predominance in the equity index futures and options business.  Euronext.liffe have launched new services aimed at providing the certainty of counterparty credit, legal and operational issues while allowing users to still operate in an OTC environment.

Eurex’s response to this has been a flex option facility and an extension of the block trade fee caps that had been in place for individual stock options to equity index options, thereby allowing participants to arrange larger trades ‘OTC’ and then use the exchange’s systems to book the trade while keeping costs down to the fee cap per product.

These initiatives should greatly increase the level of business that is traded on exchange.  In addition, the Eurex introduction of volatility futures for the DJ EURO  STOXX, DAX and SMI markets are an attempt to provide more efficient volatility hedging for both ‘traditional’ equity hedge fund managers and the more nascent volatility arbitrage hedge funds which have around $1billion under management.

Finally, looking toward Asia, it is clear that some of the derivative exchanges in the region have already experienced phenomenal growth, with South Korea coming to mind immediately with their Kospi contracts.  This is ‘despite’ the fact that the Asian hedge fund industry is much less mature than the European and US industries, with assets growing circa 30% in the first half 2005.

Therefore, if the other geographical regions are a potential guideline, the expected increase in Asian derivative exchange volumes could be even greater than market commentators suggest if the level of hedge fund activity continues to increase in the region.

Of course, all of the increase in exchange traded derivatives should not be attributed towards hedge funds.  Traditional fund managers are using techniques now that are aimed at producing absolute returns and increasing the returns on their traditional portfolios.

One way of achieving this is via portable alpha, whereby traditional managers use bond or equity index futures to replicate the beta exposure of their portfolio and then take the excess cash available (as they can achieve the same nominal exposure via futures with only an initial margin requirement) and invest in hedge fund like techniques to achieve additional alpha returns for the portfolio.

Of course, it is also possible to generate alpha via derivatives themselves but it would be fair to say that there are not too many managers taking such a sophisticated approach. There are also academic papers that suggest that hedge fund return replication using only derivatives is possible so perhaps this may be another source of business going forward?  Certainly there is a blurring of the difference between the activities of some ‘traditional’ managers and hedge fund managers as the money management industry seeks better returns.

In summary, it would appear that while the assets under management in the hedge fund industry continue to increase the exchange traded derivatives business will continue to flourish.  It is clear that the liquidity and transparency that is provided by flagship bond and equity index futures contracts will continue to be the focal point of hedge fund industry activity.  The levels of open interest on such contracts are even more impressive than the average traded volumes, which is a good sign that there is a healthy mix of all types of end customer/agency business that are holding positions and is the cornerstone for further increased activity.