Euroland investors take to equities diversificatio
The first year of the euro has offered European investors interesting choices with respect to diversifying away from their domestic equity markets and into the broader equity universe on a Euroland and pan-European basis. The trends in equity derivative usage last year show a dramatic increase in the use of regional futures and options. The most noticeable trend has been the explosion in the use of Euroland derivative products.
Although growth in this area was a feature of markets in 1998, the actual final implementation of the euro has witnessed a boom in trading Euroland futures contracts. This has been particularly evident in indices such as the Euro Stoxx 50 where the futures now often trade significantly higher volumes than even long established local index futures such as the Cac, FTSE, AEX and Mib. Similarly, there has been an explosion in listed options volumes. In aggregate, after the Dax and the FTSE 100, the Euro Stoxx 50 has become the third largest index with associated derivatives products. All of this progress has occurred in little more than a year. Rather than focusing on the nature of the individual index product it is perhaps more useful to consider the relative merits that such diversification has offered investors.
Whilst the trend in derivative use is indicative of the broadening of investor acceptance of the need to diversify away from local equity investment there has been a noticeable shift in terms of the types of investors participating in this market shift. Certainly the initial flurry of activity was from institutional investors keen to take advantage of the investment opportunities afforded by the euro and the enhanced range of new domestic equities. Clearly the lack of currency risk has provided the main impetus for this shift whilst investors have also been able to benefit from the general improvement to their portfolio risk and return characteristics.
The broader change that has been evident has been from retail investors, who dominated investor flows for much of last year, such that retail investment products have been an important factor determining market flows. Retail participation has been a factor in the rise of the popularity of such narrow indices as the Euro Stoxx 50, with investors that previously held narrow 30–40-stock indices being content to own a basket of only 50 large capitalisation names.
At an individual country level it is possible to analyse the major impact from an investor perspective, the analysis looks at the historic risk return profile over the past five years for various local indices and the Stoxx 50 and Euro Stoxx 50. In general these trends have been relatively stable.
For German investors which had previously been focused on the Dax the benefits from shifting benchmarks have been considerable. Specifically, a shift to Euroland investing means no currency risk and the potential of both a higher return and lower risk. It is possible that German investors could benefit even further from a shift to pan-European investment. However, this would involve taking on currency risk for almost 45% of the portfolio. For French investors the diversification benefits are just as clear, although the risk reduction is lower than for German investors. Interestingly, French investors have been less aggressive when it comes to shifting their portfolios away from their traditional domestic bias. Certainly in 1999 this was a successful strategy, with the Cac outperforming all other Euroland indices.
The situation is not so clear-cut for UK investors where a shift from the domestic equity market would imply potentially higher returns – albeit in conjunction with a significant increase in portfolio volatility. It is clear that UK investors are generally reluctant to assume sizeable currency risk as the timescale for possible euro entry has lengthened considerably over the past year. In addition UK investors are typically overweight equities relative to bonds and as such have less scope to shift portfolios and invest in Europe.
The choice of a narrow index in preference to a broader and more representative benchmark is also unusual and whilst it is relatively easy to understand the retail aspect to this demand the institutional demand has been driven by access to a liquid futures contract. In fact it is clear that investors prefer liquidity and market exposure ahead of pure tracking error considerations. Interestingly, both narrow indices offer investors a better alternative to the broad benchmark. However, much of this benefit is a function of the outperformance of large cap stocks. A more measured approach using the broader indices is likely to evolve over time.
Overall, following a year when diversification has been shown to offer investors considerable benefits from a portfolio perspective we expect this trend to continue during 2000. In fact after the initial urge to diversify institutions have generally slowed the pace of portfolio rebalancing and it is likely that a further wave of portfolio shifts will occur as investors continue to appreciate holding non-domestic equities and the enhanced returns and lower risk profile that this offers.
Nizam Hamid is director, derivatives and portfolio trading, at Deutsche Bank in London