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Synthetics attract institutional investors
16 August 2012
Institutional investors are utilising synthetics to achieve
their aims but retail investors and regulators are less
enthusiastic. Blake Evans-Pritchard reports
Four years on from the start of the financial crisis, investors have regained their appetite for hedge funds. A recent survey by Deutsche Bank puts the global value of hedge funds at US$2trn at the end of last year – which represents an increase of 222% since the bank fi rst began surveying investors in 2002.
The bank predicts that hedge fund assets could rise a further 12.4% this year. Beyond the headline figures, however, investor appetite for hedge funds has changed. In line with the inevitable risk aversion that accompanies volatility, institutional investors are increasingly looking for protection as much as seeking outright returns.
Long-only funds are likewise increasingly moving away from their traditional benchmark return strategies and introducing more cross-asset funds that specifi cally target absolute returns, according to Murray Roos, co-head of European equities at Deutsche Bank. Looking for ways to hit return targets can often means exploring opportunities beyond domestic borders.
The problem is that, for many of these emerging markets, getting a foot in the door can be costly. This is especially the case if the fund has exposure beyond the most developed economies.
“The infrastructure and footprint required for access can be prohibitive,” says Roos. “A lot of markets have restrictions on foreign ownership of securities and those that are allowed to trade them. As an investment bank, we can use our balance sheet to invest directly on the exchange and then offer synthetic instruments to customers.”
Such costs push absolute return managers to utilise synthetic finance based in major financial centres. However, synthetic products are increasingly coming under the watchful eye of regulators, who argue that, if a particular type of investment is restricted under one set of rules, then it shouldn’t be possible to use a synthetic solution to legally bypass the law. This ongoing discussion is likely to affect the way that synthetic products are developed and used.
“When it comes to regulation, one thing seems certain – we’re going to get more of it, and not less,” says Colin Bugler, the head of portfolio solutions at ING’s Global Securities Finance, which set up a synthetic prime brokerage business specifi cally to target emerging markets. “This has cost implications for investment banks providing synthetic products, which will ultimately have an impact on pricing.”
The main reason to use synthetic products, according to Roos, is for market access. “It wouldn’t make commercial sense for a hedge fund to pay licence fees to become a member of a local exchange just to invest 5% or 10% of their investment fund. It’s much easier for them to transact through us, since we are in these markets already.”
Such access products tend to be most popular for emerging markets, where governments feel they have to protect their economies from potentially destabilising foreign investment. Synthetic solutions are less useful for exposure to developed markets, as the fees often outweigh the benefi ts, but some banks have introduced bespoke products for clients, such as synthetic access to a portfolio spanning several different currency baskets.