Matthew Craig charts the differences between delta one products and how they can serve a range of investment purposes
The words ‘delta one’ might sound rather like a call sign from a war film, but in the world of finance they have a rather more prosaic meaning.
A delta one product is a derivative that faithfully tracks the performance of an underlying asset. If the underlying asset increases by 1%, then a delta one product increases by 1%. In other words, it has a delta, or sensitivity to the price of the underlying asset, of one. Swaps and futures can give this type of exposure, as can plain vanilla ETFs that track a market index without gearing or leverage. But swaps, futures and ETFs have a number of important differences and investors need to look at these when deciding which tool best suits their purposes.
An obvious starting point is tracking error, or deviations from the benchmark. ETFs in large, liquid markets should have very low tracking error, but this is likely to increase in less liquid markets. Martin Bednall, director of product development for iShares, said: “I don’t think any instrument will give perfect tracking as there will be costs involved in tracking an index. You can also outperform an index and that causes tracking error.”
However, Daiwa Capital Markets head of synthetic trading Simon Roche said: “Total return swaps and futures typically have no tracking error, as by definition derivatives are based on the benchmark they are tracking.”
On the other hand, because ETFs trade like shares, in theory, a single ETF share could be bought and sold, in contrast with other delta one products which require larger minimum size investments. Claus Hein, head of Lyxor ETFs for the UK, Nordics and Latin America said: “The minimum size to trade an ETF on-exchange is one share and, as a result, they can be used for precise allocations compared to other delta one instruments with larger minimum trading sizes. At the same time, investors can trade via multiple ETF brokers and, if necessary, they can easily adjust their positions throughout their investment time horizon in an effective way.”
It is harder to give a minimum investment for swaps or futures, as they can be bespoke, but it will usually be much higher than for ETFs. BNP Paribas Asset Management co-head of EasyETF and index development Danièle Tohmé-Adet commented: “Investors normally need a significant minimum size to deal in swaps. It is usually €1m or €2m or sometimes as much as €5m.”
However, Roche said that there is no fixed minimum for swap transactions; it entirely depends on the lengths an institution is prepared to go to for a client. This is because swaps are traded over-the-counter (OTC), rather than on an exchange.
Futures are traded on exchanges such as the New York Mercantile Exchange or the Chicago Board of Trade. A minimum of one contract has to be traded and this will typically be around $50,000 to $100,000 in value. Futures contracts are sometimes traded in blocks, to enable larger transactions to complete smoothly.
Rob Flatley, chief executive officer at Netik, an information provider on delta one products, said the minimum for block trades is usually 500 to 1,000 contracts. But it is possible to deal futures in smaller amounts than this. Roche said: “We are very keen to get new equity derivatives business and are trying to be as flexible as possible. We have got a lot of traction with smaller funds by saying we are not going to impose a minimum size”.
A major advantage of ETFs is the ease of investing in them. Anyone can trade ETFs via a stockbroker or investment platform, whereas investing directly in some derivatives may be beyond the powers of some investors, such as local authority pension funds. Investors wanting to trade futures will need to have a relationship with a member of a futures exchange and these institutions will generally want this to be worthwhile for them.
To trade OTC swaps, investors have to have an International Swaps and Derivatives Association (ISDA) agreement in place for every broker they use. Consequently, many conclude it is simply easier to invest in underlying markets by using ETFs. Iveagh Wealth Fund portfolio manager Chris Wyllie said he tended to use plain vanilla ETFs for their ease and simplicity, with a leaning towards swap-based ETFs, which usually have low tracking error. He added: “We prefer to have someone else dealing with all the documentation. Provided they are not taking too much out, we think that’s a service worth paying for.”
While ETFs may be the easiest to trade, OTC swaps are the most flexible in terms of tailoring the trade, because this can be agreed on a bespoke basis. “You can literally trade anything you want with total return swaps – they are super flexible”, Roche said.
In contrast, the range of futures traded on exchanges is vast. ETFs, however, are one of the fastest growing areas of the investment universe. According to BlackRock, there were 2,308 ETFs with 4,922 listings at the end of August 2010, spread among 129 providers and listed on 43 exchanges around the world. Iveagh’s Wyllie said: “There have been occasions when the ETF universe is slightly more constrained than we would like, but it is not so constrained that we have to go much further than we want to”.
A question of risk
Risk, particularly counterparty risk, is another important factor to consider. The dramatic collapse of giant investment bank Lehman Brothers in 2008 graphically illustrated the risks of using a product underwritten by a single counterparty. OTC swaps leave an investor heavily exposed to the counterparty writing the swap, such as a bank. “If they go bust, you are going to lose the value of the swap”, Roche said. But futures traded on an exchange will be subject to novation, where the clearing exchange becomes the counterparty to all trades, so if the institution that originally provided the future becomes insolvent the counterparty is protected.
For ETFs, the degree of counterparty risk depends on the provider and how the ETF is structured. “For ETFs holding physical assets, there is no counterparty risk unless there is securities lending by the product. The counterparty risk there should be covered within the fund structure by collateral positions,” said Bednall at iShares.
If ETFs used swaps to obtain index performance, this introduces counterparty risk. However, Tohmé-Adet pointed out that ETFs comply with the Ucits III regulations, which limit counterparty exposure. She said: “Swaps and certificates can have 100% counterparty risk. With ETFs, even if they use synthetic replication, they can only have a maximum exposure of 10% of the net asset value of the fund to a single counterparty.”
Pricing risk is another important consideration for investors. This is because the price of a future implicitly includes expectations on factors such as dividends or interest rates, which could lead to a loss if these expectations are wrong. This risk is not present in total return swaps, which are based on shorter periods and is one reason why hedge funds increasingly prefer total return swaps to futures.
Yet, one possible disadvantage to ETFs is their trading hours. Anello Asset Management managing partner Mark Hewlett said: “Most commodity markets are open 24 hours a day and ETFs only trade during stock market hours. If you invest in commodities you can see wild swings and if the UK market is shut, then a stop-loss order with a UK-based ETF would not be triggered.”
However, Hewlett said it is usually possible to trade futures and contracts for difference (CFDs) 24 hours a day, enabling investors to take advantage of price movements outside normal exchange opening hours. With OTC swaps, it may not be possible to trade them at all, as they are private agreements between two parties.
Delta one derivatives also have the potential for leverage, or gearing, which can be useful for a fund wanting to maximise its exposure. Tax may make a difference too, as all other things being equal, any differences in the tax treatment of similar products will affect investment decisions. Flatley said: “It is interesting how different geographies have decided how they want to trade. For example, CFDs are widely used in the UK, whereas warrants are more popular in Germany. It is usually based on taxes.”
In terms of cost, ETFs have an annual fee – unlike swaps and futures – as well as broker commission paid on purchase. The annual fee on ETFs can be very low, but any such expense will compound over time and act as a drag on performance. Flatley said: “You can trade swaps and futures very cheaply, with deals being executed for nothing, or almost nothing by market makers. It is generally going to be cheaper to pay commission on swaps and futures than the fees on an ETF.”
Overall, though, the differences in cost may not be significant, as arbitrage should ensure they are all in line. Roche said: “You should be able to argue that you should be no better or worse off trading any of the products, as they all do the same thing”.
Certainly there are a number of important differences between ETFs and delta one derivatives, such as swaps and futures. For private investors and smaller funds, ETFs may be the simplest way to get delta one type exposure, but others, such as hedge funds and institutional investors, may find futures and swaps have their advantages. It really is a case of horses for courses.
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