By Andrew Webb

Derivatives are playing an increasingly important role in the high-stakes hedge fund game.

Ask any derivatives dealer about his or her client base—or the clients he or she wants to attract. Odds are good that the first two words to pop out of his or her mouth will be "hedge funds.” Armed with enormous capital resources and with minimal regulatory or accountancy restraints, these financial behemoths are voraciously roaming the globe, putting the fear of Mammon into corporates and governments alike.

As institutions with a major appetite for leverage, they have naturally gravitated to derivatives markets. But despite the scores of articles written about them, details on how they use derivatives and for what purposes have been scarce. When it comes to derivatives, hedge funds have displayed an inconsiderate reluctance to kiss and tell.

Research from specialized companies that follow hedge funds, however, has provided a peek into the important role that derivatives play. A 1996 InterSec survey of 216 hedge fund managers found that derivatives made up 37 percent of U.S. portfolios and 54 percent of U.K. portfolios. A recent survey of global hedge fund derivatives activity by Van Hedge Fund Advisors found that 75.8 percent of the 2,000 hedge funds surveyed used derivatives in their operations—46.2 percent used them for hedging only, 1.8 percent for return enhancement only and 27.8 percent for both purposes.

As important as derivatives are to hedge funds, there are also definite signs that their presence and muscle have had a notable impact on the evolution of derivatives markets as well as the internal operations of the investment banks. At the same time, hedge funds' approach to risk management has become extremely sophisticated.

Major attraction

Leverage has traditionally been the single biggest incentive for hedge funds to use derivatives. This is particularly true of global macro funds that make huge directional plays in a variety of different markets. When they decide on a particular punt, they're particularly eager to get the largest bang for their buck. Derivatives can allow the largest funds to leverage their capital bases by a factor of 10, 20 or more.

But leverage is only part of the story. Many hedge funds like the way derivatives can act as proxies for cash instruments that either do not exist or are relatively illiquid. Short-dated Japanese bonds are a case in point. While those in the two- to three-year time frame are in extremely short supply, investors can easily get exposure to the short end of the Japanese yield curve in the swaps market.

Derivatives have given a similar advantage to hedge funds attempting to exploit France's substantial yield discount to Germany. By using swaps to go long German four-year rates, four years forward, for example, a number of funds have gained the exposure and picked up the implied LIBOR financing on the trade at the same time. By contrast, executing the trade in cash bonds would involve buying an eight-year bond, selling a four-year and financing the four-year short—a series of trades that would probably destroy any potential profit in the play.

Ganging Up On Taiwan Every once in a while, hedge funds from different sectors of the market all decide to hit the same derivative product at the same time, as part of completely different strategies. When they do, the effect is little short of spectacular. One of the best examples of this has been the huge swing in the Taiwanese equity swaps market this year. After a strong 1996, many equity hedge funds that were keen to protect profits while unwinding cash equity positions started entering into equity swaps (receiving the fixed) on the Taiwanese index. Short sellers joined them as the market began to crack. A third group of hedge funds, composed largely of global macro and opportunistic/special situation players, was also using equity swaps in a similar fashion, but as a hedge for a more interesting strategy—namely buying into and breaking open the Taiwanese closed-end funds. "A lot of the closed-end funds have been trading at around 20 percent discount to their net asset value,” says one trader at a Hong Kong investment bank. "Under Taiwanese law if they trade at a greater than 20 percent discount for 20 consecutive trading days, then the shareholders have the right to call an extraordinary general meeting. This allows them to break open the fund (so it becomes open ended) and realize the full net asset value—so there's an immediate potential gain of 20 percent to be had there.” The effect of the three groups of hedge funds all opening equity swaps and receiving the fixed pushed the pricing from 300 basis points over LIBOR at the end of 1996 to (at one point) 1,300 basis points below LIBOR in 1997. —A.W.

Hedge funds also frequently use derivatives to make complicated trades that would be difficult or impossible to trade on their own. This is particularly the case with complex, multilegged trades done in multiple cash markets. Many managers who have had trouble managing the subsequent multiple cash flows of these deals have come to appreciate how they can put all the legs of a trade on simultaneously—and do so in size.

"Macro globals will use futures, forwards, swaps and options, in both OTC and exchange guises. Other classes of hedge funds, such as relative value or arbitrage, will tend to use a narrower subset of these.” Sohail Jaffer chairman, Alternative Investment Management Association

For example, a number of U.S. global macro and relative-value funds are attempting to reap a premium on the assumption of hedging the prepayment risk of mortgage-backed securities. The trade involves buying mortgages, paying fixed on interest swaps, and buying payer swaptions to lock in the mortgage spread. "They want to be able to do all that with one phone call and, at the same time, obtain attractive credit facilities or financing rates on the paper, effectively cross-margining between the different securities,” says Martin Walton, managing director of Gottex Financial products Ltd. (London), which markets the hedge funds of Gottex America Ltd.

The prospect of one-stop shopping has been particularly attractive to some equity-market-neutral hedge funds, which attempt to profit from pricing discrepancies between related securities while hedging out overall market exposure. "The big issue at the moment has been the long/short equity mean-reversion type of trade,” says Patrick Moriarty, senior vice president of Evaluation Associates, who manages $800 million in a fund-of-funds hedge fund. "Managers who don't have the credibility or capital behind them are forced to deal in one-off derivatives that allow them to take the position that a relationship between securities will revert to its long-term mean,” he explains. "Their model will tell them what to be long or short on an equal dollar basis, and the over-the-counter derivative provides that without requiring individual shorting.”

This litany of virtues, however, is tempered by the hedge fund industry's primary concern with structured derivatives products—a relative lack of liquidity. Given their typical position size, managers have little incentive to indulge in indiscriminate derivatives activity. [If it's hard enough to buy and sell the underlying, it certainly won't be any easier to liquidate a related derivative position.] Passing on the problem to a counterparty may make opening the trade more convenient, but why run the risk of getting locked into an illiquid position that will incur a major performance hit to exit?

An indication of this liquidity-sensitive approach has been the lukewarm response that "catastrophe bonds” have had among hedge funds, despite heavy promotion by several investment banks. These securitized packages of the reinsurance risk of natural catastrophes should theoretically be extremely attractive to hedge funds, as they have no correlation with bond and equity market downturns. Despite this, liquidity concerns have kept hedge funds from opening their wallets.

Hedge funds, after all, are sharp comparison shoppers, and look closely at all the possible ways of expressing a view. "We're only interested in using derivatives if doing so confers a substantial advantage over dealing in the underlying market,” says Andrew Lawrence, CEO of Rubicon Capital Management. "For example, someone with the view that German rates were too low for the next year, but too high thereafter, might choose to do a nine-year swap starting one year forward. We wouldn't take that trade, because by buying a 10-year Bund we could capture 80 percent–90 percent of its dynamic while also obtaining possibly favorable financing on the underlying collateral and gaining huge liquidity.”

Other managers have a generally skeptical approach to the exotic products commonly associated with hedge funds. "I think too many people are seduced by the greater leverage and lose sight of what they are giving up in return,” says Thymis Carolides, investment manager of Omnia Asset Management. "For example, something like a reverse knock-out option may have a premium that is only a fraction of a plain vanilla product, but the upside during the life of the option is limited, the transaction costs of hedging intrinsic profits are large and the capped payout may only be realized at maturity. We use products like that ony sparingly and only when the behavior of the instrument suits our underlying view rather than just looking at the potential leverage.”

Who's using what

Identifying which type of hedge funds use which type of derivatives strategy is, to say the least, problematic. Certain generalizations are safe to make, but many hedge funds transcend the boundaries of the categories to which they are allocated by the research companies.

Do Hedge Funds Drive the Market? Hedge funds have made their presence felt on derivative desks in a big way. Many institutions have set up specific desks dedicated to the care and feeding of these sophisticated clientele. This development has not gone unnoticed by second-tier banks, which are trying to diversify their revenue stream away from traditional markets. Some of the derivative products that hedge funds require, however, would severely stretch the hedging capabilities (and possibly the capital base) of all but the largest banks. While the premium available on products such as emerging market power options may be attractive to potential newcomers, only a few dealers are likely to be capable of making a meaningful market in them. Even then, there's no automatic guarantee that exotic product equals exotic margin. With so many new derivatives being made up of a combination of existing products, any bank trying to charge the full bid/offer on each component is definitely going to lose the business. The assumption that hedge funds will provide a ready market the latest complex structured product is also wide of the mark. Do hedge funds drive the development of new derivatives products? They've certainly helped make many kinds of exotic options popular. In the case of FINEX, hedge funds can even be said to have caused the creation of an entire derivatives exchange. Others are less convinced. "I don't think that hedge funds are pushing the creation of new products in the same way that corporates drove the introduction of diff swaps,” says Martin Walton of Gottex. "But they are changing the way that banks are looking at the different products that they are offering. The barriers between, for example, repo, bond and foreign exchange desks are disappearing rapidly because of hedge fund requirements for derivatives that cross conventional product boundaries.” —A.W.

Global macro funds are by far the biggest derivatives users. They also tend to be the most omnivorous in terms of the range of derivative products used as well. "Macro globals will use futures, forwards, swaps and options, in both OTC and exchange guises,” says Sohail Jaffer, chairman of the Alternative Investment Management Association (AIMA), an international trade association with offices in London and Paris that includes a number of hedge funds among its membership. "Other classes of hedge funds, such as relative value or arbitrage, will tend to use a narrower subset of these.”

Some hedge funds have been quick to pick up on opportunities in the credit derivatives market. The market has a number of characteristics that make it a natural fit for global macro and fixed-income hedge fund managers. A number of funds that don't have the infrastructure to buy and handle loans have been hungrily eyeing the high yields available to investors who purchase loan portfolios.

The funds are particularly attracted to the unfunded nature of credit default swaps and similar products, and typically use them to gain access to, rather than lay off, exposure. In most cases, they have a preference for credit derivatives on names that they already know and often use them on a specific name to enhance the total yield of a bond that they already own issued by that name. Hedge funds have also been heavy users of total return swaps as a means of accessing high-yield or emerging market bond indices. Their activity in derivatives on corporate credits has been marked by a preference for rated U.S. corporates individually as opposed to basket deals.

Equity-market-neutral hedge funds attempt to keep their neutrality with strategies involving straightforward shorting of equities and by using OTC long/short equity mean-reversion trades. But some have begun gaining exposure to particular indices with equity swaps or by constructing synthetic long positions by purchasing a call and selling a put.

Some of the most sophisticated hedge funds are using similar instruments to trade the relative value of stocks in special situations, such as mergers and cross-holdings. A recent popular example of this has been long Reynolds/short Nabisco. Derivatives dealers also note that global macro funds have joined relative value funds as the biggest players in these types of trades.

"The typical U.S. equity hedge fund primarily uses straight shorts, the next most common method is puts, followed by warrants and calls. However, a number of funds have been particularly active in the SPDRs (Standard and Poor's Depository Receipts) listed on the American Stock Exchange.” George Van Van Hedge Fund Advisors

Some equity funds that stick to bread-and-butter strategies have found exchange-traded index products attractive. "The typical U.S. equity hedge fund primarily uses straight shorts. The next most common method is puts, followed by warrants and calls,” says George Van, chairman of Van Hedge Fund Advisors. "A number of funds, however, have been particularly active in the SPDRs (Standard and Poor's Depository Receipts) listed on the American Stock Exchange.” SPDRs are unit trust-like securities that mimic the performance of the S&P 500 and S&P 400 Midcap. "One manager we discussed this with cited the ease with which it was possible to enter and exit positions as his reason for preferring them to an index trade as a means of going short,” says Van.

Quite a few categories of hedge funds, such as distressed securities and short sellers, make only occasional use of derivatives. When they do, they tend to use comparatively vanilla strategies—such as going long or short futures or using call or put options. Convertible arbitrage (see table) is another area that has not traditionally seen much hedge fund activity, but one or two funds have been ringing the changes here. Rather than adopting the time-honored method of buying the convertible and shorting the stock, they have been using OTC long-term equity anticipation securities as a proxy for the short sale.

Emerging markets have become the latest hunting grounds for many hedge funds. Thus far, most of the action has centered on fixed income. Derivative activity in foreign exchange has been limited as the options lack sufficient depth for funds to get the sort of size away that they want without pushing volatility through the roof. Consequently, most of the recent action in the Thai baht frenzy largely took place in the forward market, which offered sufficient depth and leverage to meet funds requirements.

One popular instrument with hedge funds active in emerging market bond options has been the so-called power call. In this variation on call options, the payout is based on the intrinsic value of the option, but raised to a particular power. The payout can thus be the square, or even the cube, of the intrinsic value. "We've seen quite a few of these,” says Robert Hedges, managing director of emerging market derivatives for ING Barings in New York. "They've been common in emerging markets for floating rate bonds because the upside in the cash market this year hasn't been tremendous. Most of the gains came last year, so the funds have been looking for maximum leverage to make the most return from the last few available points.”

In the major foreign exchange markets, a number of hedge funds have moved way beyond the comparatively straightforward leveraged forward trades used in currencies such as the Thai baht. While many try to get the biggest bang for the buck by purchasing 50-delta at-the-money options, a number of exotic options have become especially popular. Double-barrier one-touch binary options are now giving funds (mostly the global macros) an effective tool with which to play volatility ranges. For example, a fund anticipating a flat period in the U.S. dollar/ Deutsche mark rate might pay a dealer a $1 million premium up front and in return receive a $5 million payoff if the exchange rate stayed within its predetermined barrier ranges until expiry. If the exchange rate hit either barrier, the option would cease to exist.

"This is an ideal tool for hedge funds,” says David DeRosa, president of DeRosa Research and Trading. "It is the perfect way to go short of volatility, which is something that was not easily possible before. You could previously approximate it by buying a double-barrier straddle, but that was not such a clean bet. It didn't have a binary payoff, so if the exchange rate was at the strike price at expiry, there would be no payoff at all.”

A slightly less popular exotic that has still been favored by hedge funds looking for the ultimate in leverage on their foreign exchange trades is the contingent premium option. No premium is paid upon opening the position, but a number of stepped trigger levels are set below the market in the case of a call. If the market trades down to the first of these, a premium becomes payable. If it then trades on down to the next trigger, a further premium is due, and so on. If the underlying currency performs as expected and does not trade to any of the premium trigger levels, however, the leverage is potentially infinite. No premium—maximum payout.

Despite the complaints about spreads and liquidity, hedge funds seem to be finding their relationships with derivatives dealers increasingly profitable. Derivatives dealers, in turn, are happy to work with sophisticated players who do not have to get board approval every time they make a call. The cross-fertilization of ideas and techniques seems to bode well for the future of both derivatives and hedge funds.

The Hedge Fund As Risk Manager At first glance, it might be difficult to think of two more unrelated topics than hedge funds and risk management. Nevertheless, hedge funds have a far more integrated (and possibly sophisticated) approach to risk management than either investment banks or more conventional asset managers. Funds specializing in more quantitative approaches, for example, seek to exploit statistical anomalies where the risk of loss is low, which requires the backing of sophisticated risk management. Their analysis seeks to answer several questions, such as: How much is at risk? Where is it at risk? What is the maximum loss? The answers are then fed back into their trading strategy. "From their perspective the process is not only important for risk management—it's the whole basis of their trading,” says Satyajit Das, risk management consultant and author of a number of texts in the area. "They are naturally better at risk management than conventional funds that are measured against an index or banks that have transactions both ways and will only be managing a residual risk. They have really enhanced VAR (value-at-risk) technology into an art form.” The VAR approach to risk management, however, is not playing to packed houses. The feedback from funds is that while VAR may be interesting as a concept, its relevance for them in its simplest form is limited. Hedge funds may want dollar value risk figures, not on the basis of some historical variance, but really focusing on extreme events. A risk manager at a bank is usually interested in trying to protect its capital, while a hedge fund manager wants to know what the risk numbers are telling him about how he trades. While most hedge funds make use of VAR in some form, they will typically supplement this with complex structured Monte Carlo simulations, which give them a far clearer picture of what happens if a shock impacts the portfolio. They're also often interested in playing statistical anomalies, which Monte Carlo tends to throw up. This is especially true when funds are trading correlation differences. These are difficult to model with VAR, which is developed under constant volatilities and correlations and cannot produce meaningful results for a trade that is based on fluctuations in these elements. "If you have a position in, say, French and German bonds, VAR could let you offset the positions with each other and allow you to increase leverage,” says a prominent hedge fund trader. "I disagree with that approach, because once you step out of cash vanilla bond buying and employ leverage, it behooves you to assume that there is no correlation between the positions and that both can go against you on any given day. That comes from my bias that using historical correlations in order to employ higher leverage makes the judgment that the past is a good predictor for the future even more hazardous. VAR also has no answer for systemic risk, such as a collapse in the availability of credit, which represents the biggest hazard for a large macro hedge fund.”

Types of Hedge Funds and Their Strategies

Type of Fund	Definition	Typical Hedge Fund Trades
Aggressive growth	Usually investing in small/microcap stocks, which are expected to appreciate rapidly. Expected acceleration in growth of earnings per share.	Index options—puts mostly, on S&P and NASDAQ.
Distressed securities	Buying equity/debt of companies that are in or face bankruptcy, in the hope of company recovery.	Occasional market puts against sharp market drop.
Emerging markets	Investing in equity/debt of emerging markets. Strict definition of emerging market is one with GNP of $7,620 or less in 1990 (World Bank).	Equities: Most frequently used derivatives are index options, as available, with some shorting of ADRs as available. Fixed income: occasional interest rate swaps. Currency risk: options, futures and swaps.
Fund-of-funds	Manager invests with other money managers or pooled vehicles that may utilize a number of trading styles, thus creating a diverse instrument for investors.	Puts against market drops, used very infrequently.
Income	Investment with a focus on current income/yield rather than solely capital gains and appreciation over time.	Derivatives used for hedging primarily (although occasionally for investment). Some use of swaps and/or fixed income futures (e.g. T-bill futures).
Macro	Global or international investment that employs "top down” approach, following major changes in global economies and hoping to realize significant shifts in global interest rates and so on.	Broad use across of most types of derivatives, depending on fund strategy. Liquidity constraints are a major concern. Derivatives tend to be used more for investment purposes vs. hedging than for in most other styles.
Market neutral—arbitrage	Manager focuses on obtaining returns with little or no market correlation. Typically buying/selling different securities issued by the same company and exploiting pricing discrepancies between them.	Often hedge with put options. For example, convertible arbitrage funds using put options when stock to short not available or too expensive.
Market neutral—securities hedging	Manager is long some securities and short others, with no correlation between the two groups in an attempt to exploit over/underpricing.	While shorts are usually used as primary hedging approach, covered options and OTC products such as puts are sometimes used.
Market timing	Large positions in one or two asset classes depending on market or economic outlook. Objective is to anticipate timing of when to be in or out of market.	Occasional use of index futures for quick market action.
Opportunistic	Manager changes from strategy to strategy as seems appropriate. Can use one or more disparate investment styles independent of approach or asset class.	Occasional use of puts vs. shorting against individual stocks or market downturns.
Several	Using a mixture of other strategies in this table.	Use depends on styles (see other styles).
Short sellers	Strategy consists of identifying overvalued companies and selling short their stock.	Occasional use of puts for shorting.
Special situations	Typically "event driven.” Significant positions taken in a limited number of companies with "special situations,” such as reorganizations, emerging bad news.	See opportunistic.
Value	Investing in stocks believed to be trading at a discount to their intrinsic or potential worth.	Limited use of stock and index options for hedging of individual positions or hedging of portfolios.
Source: Van Hedge Fund Advisors and Evaluation Associates