In Depth

Responding To Convergence: Derivatives

Mar 16 2007 | 12:51pm ET

To highlight the nature of proliferation amongst hedge funds, it is important to note that, although institutional and high-net worth funds experienced dramatic growth rates of 260% and 200%, respectively, since the early 1990s, the number of retail funds only grew by 48%. In fact, the number of retail funds has declined by 9% since 2000. 

With so many products in the market and with returns converging, how might hedge funds respond? Our research clearly indicates that institutional funds are using increasingly innovative products to differentiate themselves, while retail funds lag behind.

Core Products

We begin with the trends for the two most common products, common equity and corporate bonds, as seen in figure 1. It should come as no surprise that these products do not appear to be a differentiating factor across the fund classes with their widespread usage indicated in Figure 1.  Incidentally, a similar lack of differentiating ability is observed for several less common instruments including convertible bonds, government bonds, ETFs, and mutual funds.

Another trend worthy of note is the convergence seen in figure 2. Could this trend indicate that funds are taking similar approaches to risk diversification, especially since these instruments are most often used to create synthetic exposure to commodities and foreign markets?

Product Innovation

Differentiation emerges when the focus moves to riskier instruments. In figure 3, we see the trends for options, rights and warrants. Since 1998 and the Long-Term Capital Management crash, the presence of options, rights and warrants in fund portfolios has diverged by fund category.

Currently, options usage is reported by 48% of institutional funds, compared to just 35% of retail funds; for rights and warrants, the figures are 26% and 20% for institutional and retail funds, respectively.

Are institutional funds using instruments like options to differentiate their investment strategies?

A Sign of Innovation?

In addition to the trends in the five most common products, swaps are gaining popularity amongst institutional funds.  Figure 4 shows why swaps present a good example of successful product innovation. In the 1991-1995 timeframe, about 2% to 3% of all funds used swaps. Since that time, almost 15% of institutionals have reported using swaps, whereas retail funds have only recently “discovered” the instrument. Are certain funds using swaps to signal a willingness to innovate?

 

 

By Irene E. Aldridge and Steven F. Krawciw

Irene E. Aldridge, Columbia MSc, INSEAD MBA, is a sales and quantitative trading professional. Steven F. Krawciw, Wharton MBA, is a specialist in Wealth Management product development, positioning and operations. Please feel free to contact the authors at insights@finalternatives.com.


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