Innovative products enliven the market
The major trend in European derivatives has been the degree of innovation in terms of the listed derivatives markets. This ranges from the initiatives into single stock futures as developed by the London International Financial Futures & Options Exchange (Liffe), which include both domestic and a range of European and US stocks, or the more domestic futures created by Meff to trade domestic equities. In addition to this there has been a significant new emphasis by exchanges on exchange- traded funds (ETFs), with the creation of dedicated new market segments designed to allow investors to actively trade these products that are new for Europe. Recently there has been a concerted attempt to create demand for sector-based liquidity through the listing of sector-specific futures.
As in 2000, the most significant trend that has been discernible in the listed derivatives markets has been the decline in usage of local market listed products and the continued expansion of the regional products. In particular the Euro Stoxx 50 has become firmly established as a highly liquid contract that allows investors to efficiently manage Euroland risk and flows (see table). The past year has also been notable for the considerable change in market conditions and the subsequent shift in investor attitude towards risk. The increase in depth in the derivatives markets has resulted in effective hedging opportunities as investors have been keen to participate in products that offer a lower risk profile than simple long equity funds.
Interestingly European investors have been exposed to a huge range of market conditions in the few years since diversification into the equity market became an important feature. Euroland investors that had been long-term bond investors increasingly diversified into equities in the lead-up to the introduction of the euro and the harmonisation of Euro-land interest rates. Investors therefore shifted in the space of less than four years from bonds to significantly higher risk equities that offered strong returns. In the past year Euro-land equity investors have had to cope with the reality of indices such as the Stoxx 50 and Euro Stoxx 50 declining by more than 20%.
The dramatic rise in market volatility has also been an important factor, with even the broad Stoxx benchmark historic volatility rising from a mere 12% in January 2000 to more than 24% at the end of March 2001 (on the basis of historic 30-day volatility). This extreme combination of high volatility and weak equity returns has shifted the trends in the derivatives markets.
Investors are increasingly looking for diversification opportunities so as to manage risk more appropriately as well as to create more focused investment products. The widespread use of the narrow Stoxx blue chip indices, in particular the Euro Stoxx 50, has led to investors owning products that have large-scale single stock/sector concentration.
Most notably, Finnish telecoms company Nokia had to be capped at 10% in the index, leading investors to minimise their exposure to the stock when it went above 10% on an intra-quarter basis. The fact that Nokia is now only 6.75% of the Euro Stoxx 50 and has fallen by more than 42% in the past three months shows the high level of risk assumed by investors in narrow indices. This high level of single stock and sector exposure has caused investors to seek out effective sector diversification methods and to pursue sector asset allocation strategies.
Another example of single stock exposure was Vodafone in the UK, which at one point, following the acquisition of Mannesman, was more than 15% of the FTSE 100 and is now only 9.36%. The availability of listed derivative products that allow investors to manage such significant stock-specific risk has been important. The recently introduced Liffe single-stock futures would have been particularly useful for investors. The success of single-stock futures contracts in the Spanish market is a good indication of how investors with holding constraints can use futures. The Ibex 35 is a highly concentrated index with Telefonica representing almost 26% of the index, BBV a further 15.3% and BSCH almost 15%. Therefore just three stocks represent over 55% of the index and the single-stock futures allow investors a useful alternative to owning the underlying stocks.
The listed derivatives market has only recently embraced the need to consider sector diversification. In 1999 the French derivatives exchange created futures based on the Stoxx sectors. Unfortunately, they were considerably ahead of their time in terms of investor demand and suffered from extremely sporadic trading and limited liquidity. In 1999 and early 2000 investors saw little need to diversify and were more than willing to accept overweight positions in the technology and telecoms sectors (overweight relative to the broad benchmark). The evolution of market returns has created an environment where products with a lower risk profile are clearly attractive.
Investors that have been exposed to Euro Stoxx 50-only products have recently been taking a far greater interest in lower volatility and more defensive areas of the market. The new sector futures listed on Eurex offer investors a limited ability to diversify their portfolios. Unfortunately futures only exist on four sectors banks, healthcare, technology and telecoms (although eight futures exist covering both Stoxx and Euro Stoxx indices).
It is now possible for investors easily to combine products hedged using the Euro Stoxx 50 and relevant Euro Stoxx sector to change the risk profile. Stoxx-based sector futures provide a useful platform for investors to pursue sector asset allocation strategies. However, the four sectors represent only 42.8% of the Stoxx and 38.9% of the Euro Stoxx benchmark thus offering only limited sector strategies through the listed futures market. To offer a more complete set of diversification tools, Deutsche Bank has created a full range of equity swaps, options and warrants available on all the Stoxx and Euro Stoxx sectors.
Although it is too early to determine whether sector futures will be successful the fact that they are listed on Eurex which already has the dominant market shares in the European listed equity derivatives market should be a positive development. We envisage a market environment where liquidity shifts from the Euro Stoxx 50 into sector strategies.
In addition to the new sector futures we believe that the European investment landscape will also be increasingly focussed on the emerging market for ETFs. Although already established in the US market, where the Nasdaq 100 and S&P 500 contracts are particularly liquid, ETFs are rapidly becoming the product of choice for exchanges seeking to capture new pools of liquidity. The major issue for European investors will be the creation of tax-efficient and liquid ETFs. It will be important for exchanges to avoid the main problem of the US market, which is that of an excessive number of products of which only three actively trade. The European market place is also very different, in that distribution of listed ETF products will be a more important boost to product liquidity than it is in the US, where retail is a significant user of ETFs.
European exchanges have been relatively keen to create dedicated listing and market environments for the issuance and trading of exchange traded funds. This has been particularly important for exchanges that have been striving to build both market presence and liquidity in an environment where the major exchanges are attempting to establish dominance and demonstrate product innovation. The past year has also been characterised by exchanges actively seeking to merge to create stronger pan-European trading platforms for investors and by aiming to capture increased order flow.
The first European exchange to create a dedicated market segment was the Deutsche Börse, which created the XTF platform. The main advantage that the Deutsche Börse has been able to exploit is a more product-oriented approach to launches on its exchange. In addition, the exchange has been able to exercise a degree of selectivity that has meant that early products have been more clearly positioned as being relevant to the domestic German investor base. Another positive factor for the Börse, and liquidity on the XTF platform, has been the initial choice of Stoxx 50 and Euro Stoxx 50-based products. This has effectively set the tone for the other continental European exchanges looking to create equivalent product opportunities. The Listed Diversified Return Securities (LDRS) product is now listed on the XTF, Swiss Exchange ETF segment and the Euronext ETF segment called NextTrack. In the UK, the extraMARK, has been created as an equivalent ETF market initiative, however volumes have been relatively low. This has been as much a function of recent poor market conditions and the general decline in retail investor activity, as well as an evolving set of products. The UK market is solely focused on various iShare products that offer a range of investment opportunities from the FTSE 100 to a range of pan-European sector ETFs (based on Bloomberg indices).
While ETFs are not naturally difficult products to understand there is a clear learning curve for retail investors, especially given the European retail investor trends in using either guaranteed investment products or at the other extreme warrants and other highly leveraged instruments. Unlike the huge retail investor market that exists in the US, the European market remains structurally different. The main distribution mechanisms are not similar and there is the general issue of Europe having a higher cost structure for equity product creation and marketing. As well as a savings market that remains dominated by retail banking products rather than low cost index tracking mutual funds. The cost issue is likely to hamper the development of retail participation in the European ETF market, although the creation and listing of ETFs by institutions that have there own extensive distribution capabilities may help generate liquidity. Ultimately the European retail market will develop differently from the US in terms of ETF usage.
For institutional investors the attractions of ETFs are perhaps limited by their access to efficient programme trading facilities and the use of OTC derivative products. Another problem with ETFs is that, in striving to appeal to retail investors their construction will deviate substantially from the typical instruments that institutional investors would prefer to use. This seemingly incompatible set of objectives is likely to split liquidity in the ETF market and also risk encouraging the creation of an excessive number of products.
Overall, the key feature of the European derivatives landscape over the past year has been the emergence of innovative new products ranging from single-stock futures, sector futures and ETFs. The dominance of liquidity on Eurex and in the Euro Stoxx 50 also offers opportunities for investors to seek out more efficient diversification strategies. This is likely to be the main area for new business as markets experience high volatility and extreme stock and sector performance.
Nizam Hamid is director derivatives and portfolio trading research at Deutche Bank in London