Changing dynamics of derivative landscape
The discussion about trends in European derivative products and indices has changed significantly in the past year. Whilst there remain a total of eight regional European index-based products, it is clear that volume and liquidity is focused in the Euro Stoxx 50 futures and the associated options.
The index and the contract are now so dominant that, although the issues regarding country and sector representation, tracking error and size bias remain, it is evident that the market prefers liquidity. Even when compared with other purely local indices it is apparent that the Euro Stoxx 50 has achieved a relatively strong position.
Comparing trading data since the beginning of the year gives a reasonable guide to how even recently the contract has become increasingly well established. In terms of average daily volume, the contract ranks third in Europe after the Cac and Dax. Looking at actual turnover, the Euro Stoxx 50 ranks sixth and, more importantly, this has been a steadily increasing trend. Over the past month the contract was in fact the second highest by volume and the fourth highest by value (see Figure 1). The advantages of large-cap Euroland diversification have clearly become increasingly apparent and the contract has benefited accordingly.
Much has been made of the virtues of the indices and futures products based on the MSCI benchmarks, FTSE Eurotop and the new S&P Euro and Euro Plus indices. It is clear that, should one consider the tracking error of an index as the best means to assess index suitability, then from a portfolio perspective indices such as the MSCI Euro and Pan-Euro would be ideal.
The MSCI indices over the past year have had annualised tracking errors of between 1% and 1.3%. These are the lowest tracking errors of any of the ‘narrow’ derivative-specific indices. This becomes apparent when one considers that the Eurotop 300 ex-UK index has a tracking error to its underlying benchmark of between 4% and 4.5%. This is both undesirable and likely to deter investors, especially in the context of the futures having almost zero liquidity. In contrast to this, the Stoxx 50 has a tracking error that has varied between 4.7% and 5.3%, which is exceptionally high. Even the extremely successful Euro Stoxx 50 contract has a relatively high tracking error of 3.4–3.8%.
Ultimately the benchmark issue in Europe has not changed over the past year. We still believe that MSCI has a dominant market share of long-term continental European equity institutional funds.
This is likely to continue, as such investors have little to gain from switching benchmarks. In the UK, investors are overwhelmingly focused on the FTSE family of indices, although relatively few use the Eurotop 300 or Eurotop 300 ex-UK. The main strength of the Stoxx indices has been in the retail investment market, which is very product-oriented, and with relatively new equity investors who are diversifying from their local indices to Euroland and pan-European investment strategies. The retail investment market has also been highly focused on implementing sector investment strategies. These have been particularly attractive as market performance has been dominated by the exceptional returns of the telecoms and technology areas. Ultimately, the retail market has been a major source of new liquidity and this has been the main reason for the success of Stoxx-based products.
Institutional investors have been attracted to the Euro Stoxx futures contract by its high liquidity. This is a function of the hedging required for the enormous range of retail products that exist. It is reasonably clear that few investors are willing to switch their futures exposure from the Euro Stoxx contract to one of the competing indices. This is evident from the fact that there have been four futures expiries that would have given investors the opportunity to roll their positions from the high tracking error Euro Stoxx 50 to a relatively better tracking MSCI index.
It is clear that, although successful and liquid, the product is not ideal as a standalone derivative contract. To understand why investors have chosen to remain focused on the Euro Stoxx 50 it is best to consider the use of the futures contract from a portfolio perspective.
From the perspective of a Euroland investor wanting exposure to just the MSCI Euroland index, or Euro Stoxx for that matter, it is possible to show that the Euro Stoxx 50 adds considerable value. If it were really possible to trade the MSCI Euro contract then investors would be able to obtain a tracking error of approximately 1%. However, in the absence of such liquidity, investors have previously chosen to own a full range of local index derivatives such as the Dax, Cac, Mib, AEX and other contracts. In fact, owning a basket of seven major local index futures would give a tracking error of 2.8%, which is considerably greater than if one could use the relevant MSCI futures contract (see tables).
The interesting portfolio aspect is that a basket of futures that included the Euro Stoxx 50 as well as local indices actually offers a better solution. Again if one were to use seven futures to track a benchmark such as MSCI Euro it would be possible to achieve a tracking error of only 2.2%. This tracking error is a meaningful reduction from that achieved by using purely local indices. Thus the combination of the Euro Stoxx 50 and local indices adds value while also offering enhanced liquidity compared to the equivalent MSCI Euro or FTSE Eurobloc 100 contracts (see Figure 2). The trade-off between tracking error and liquidity is clearly academic when the comparison is actually against a contract that has almost negligible liquidity.
Pan-European investors can also benefit from using the Euro Stoxx 50 in a portfolio context in conjunction with other local index contracts. Again the theoretical tracking error using an MSCI Pan-Euro contract is a relatively low 1%. As this is not a realistic trading proposition, investors tend to buy a basket of local index futures. A basket of the eight major local indices would give a tracking error of 2.1%. Using the Euro Stoxx 50 as a proxy for Euroland and then just including the three other local indices, the FTSE 100, SMI and OMX, raises the tracking error to 2.4%. Although the tracking error is higher, one benefits from the efficiencies of having to manage only four listed contracts rather than eight. If one is constrained to only owning four local futures, excluding using any regional contracts, the tracking error would increase dramatically to 3.65%. So for investors that wish to access the European market, the combination of the Euro Stoxx 50 and three liquid local indices serves a useful purpose and adds value.
In conclusion we can see that the last year has really changed the dynamics of the derivative landscape in Europe with the issue of benchmarks and contract success being definitively answered. The Euro Stoxx 50 has become dominant due to the high levels of liquidity and interest from the retail investors that have been important in terms of money flow, while also benefiting considerably from first mover advantage. From the perspective of institutional investors, the contract now offers both respectable levels of liquidity and value added in combination with existing local indices as a means of hedging both Euroland and pan-European portfolios.
Nizam Hamid is director of derivatives and portfolio trading research at Deutsche Bank in London