Be careful if you play with fireworks – derivatives and the buyside

Greenwich Associates has today reported on the widespread use of equity derivatives among institutional investors:

  • 81% trade single-stock options
  • 75% trade index options
  • 74% using ETFs
  • Two-thirds using index futures

It doesn’t report on how effectively they are being used, nor the processing & reporting issues their inclusion in portfolios is causing those same firms – most buyside firms draw from the same small pool of systems and most of those systems cope poorly with derivatives. They normally struggle to show the economic exposure resulting from holding options – simply showing their market value e.g. an option may have a low market value and almost be insignificant in materiality terms, but actually be equivalent to holding a sizeable share position.

I notice that volatility swaps are not mentioned in the top list – this is a straight bet on how volatile prices are and which pay out if price movements exceed pre-set targets. These are becoming popular amongst managers desperate to generate alpha because of the stellar payouts that can occur with these instruments.

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