Designed to take the weight off

They are best appreciated as a hedging and asset allocation tool, particularly for private client portfolios, but USFs have a much wider potential that can be incorporated into other products.

Private investors have tended to shy away from derivatives – they are best known as vehicles for leverage, lesser known for their use as an insurance policy against market downturns. Many see the trading side of derivatives and feel scared; they have long been equated with high-risk, short-term share punts, the province of day-traders and speculators.

Two years ago, when a 20-year ban on single stock futures trading in the US was removed, hopes were high that markets worldwide would embrace these new products as a cheap and efficient means of managing risk.

Launch

At around the same time, Euronext.liffe launched universal stock futures (USFs) – individual futures contracts which provide exposure to a range of equities from different countries and in different currencies.

Designed during the market boom, they were launched amidst a bear market and have since had to vie with covered warrants and contracts for differences as market hedging tools. USFs are essentially designed to take the “weight” off derivatives trading. They involve no borrowing of stock and can be traded on the same platform and cleared and settled under a single regulatory regime.

This means they can allow a portfolio to be diversified without entangling different regulatory regimes, slashing cross-border investment costs.

Potency

But their most potent use is as a hedging and asset allocation tool, particularly for private client portfolios.

From a wealth management perspective, there are two primary uses for USFs:

• first, as part of product-specific asset allocation and
• second, where mandates allow for unfettered direct investment.

From the traditional wealth allocation point of view, USFs can be used as part of structured funds or for products created with specific risk profiles.

Certain features of USFs have huge potential to be built into new asset management products, particularly those with a capital redemption or a capital guaranteed feature. Arbitrage funds are also expected to start incorporating USFs soon.

USFs should also appeal to the individual account manager – the private wealth manager or IFA who has retained a discretionary role.

They have the power to make direct investments into specific companies and this is where USFs have unparalleled value.

Institutional providers have started using USFs for certain types of products but for the private wealth manager much will depend on the mandates to which private banks are working.

Real value

The real value of USFs is when they are used in a discretionary management environment, which allows for the use of derivatives. This is traditionally the small pool of money left over (typically around 5–10 per cent of the entire portfolio) which clients allow managers to invest freely.

As the amount of capital in this pool is often too small for direct equity investment, USFs are handy, particularly because less money has to be offered as margin requirement.

The amount of money available here may be just E50,000, which would only allow an investor to take two or three positions with straight stock investment. The risk profile is huge, but if it’s in place in margins investors can get much more exposure to many more shares for less outlay. Diversification can be quite dramatically increased.

Shorting

Normally, shorting a stock position means the expensive and cumbersome process of borrowing it. As USFs have the ability to short the share synthetically, there is no need for this.

There are several reasons why an investor might benefit from going short. The investor may wish to hedge against the main stock investments in his greater portfolio. It may be a situation where some of the shares have lost money, yet the investor is not yet willing to crystallise a loss.

USFs can also be used to hedge out the impact of companies that may underperform. The investor effectively sells a future against the companies, thereby neutralising their position in the portfolio.

If the shares bounce back the investor can simply buy back the future. In this way USFs provide a dynamic instrument for surgically removing risk at a very low price.

There is of course, the more aggressive scenario, where leverage and the ability to short without borrowing the underlying become an important factor. If you are positive about a stock, then why limit yourself? If everybody is selling a stock that you don’t hold in your portfolio – and the analysts’ outlook is negative – there is always the possibility of taking advantage of the fall by shorting a USF.

However, one of the main strengths of this product is that USFs can be a lighter, more accessible means of varying portfolios without disturbing the original, long-term equity positions.

Market

The market for USFs has fluctuated in the last three years, but there are now clear signs that institutions and private investors are beginning to exploit them. The second quarter of this year saw a surge in volume, with a greater volume than during the whole of 2002 and a record of 1.2m contracts traded in June.

One reason for the expected uptake in Europe and further proof that the Euronext principle according to which more integration is required, is that markets are more fragmented and tend not to be as efficient as in the US. Derivatives allow greater scope to exploit inter-market anomalies and plug inefficiencies.

In the US, investors have the choice of vanilla type derivatives or cash, offered either off- or on-exchange. Many of the kinds of derivatives used in Europe, even well established products such as warrants, are unknown there. Even the wealthier investors in the US have no idea of some of the more exotic products distributed throughout the European high net worth market.

USFs are products with huge potential for private clients. With 115 USF shares now in the market, and more expected to be in circulation by the end of the year, the critical mass needed to sustain the products may soon be achieved.

Features at first glance

Here is a quick summary of the features that mark USFs’ usefulness:

• A USF is an exchange-traded product supported by market makers to ensure liquidity and transparency, all cleared through a single clearing house.
• It is a product that allows you to go long and short efficiently with only margin call.
• It can be used to hedge dynamically or leverage a portfolio and to change it without disturbing the underlying elements.

Performance enhancers

Universal stock futures offer investors many opportunities to enhance the performance of their equity portfolios, in many circumstances offering a cheap, easy and efficient alternative to trading shares or other related products.

Cheap:

• USFs are a low cost method of investing. Euronext.Liffe offers cash and physically settled contracts.
• They are a capitally efficient investment tool as you are not required to purchase the shares upfront. Instead, brokers require a minimum margin up front which is held as a deposit.
• The cost of trading universal stock futures is a fraction of the cost of trading shares.
• USFs are free from the “stamp duty” charge which is levied on UK stocks.

Easy:

• USFs enable you to trade futures contracts on many of the world’s top shares through one single point of access.
• All USF trades are subject to one set of rules and regulations.
• USFs are cleared and settled through a unified system (the London Clearing House), thereby removing the hassle and inconvenience of cross border settlement.

Efficient:

• USFs reduce the capital needed to trade when compared with shares.
• They take away the cost and administrative burden of stock borrowing for those wishing to go short (ie sell USFs).
• USFs are traded on an advanced electronic derivatives trading platform – LIFFE CONNECT™.
• The USF tool allows you to switch exposure quickly from one stock to another without the cost and inconvenience of disturbing the underlying share holding.

Contract specifications:

• Currency: local currency of the underlying
• Unit of trading: contracts based on shares of Denmark, Finland, France, Germany, Netherlands, Norway, Spain Sweden and Switzerland – 100 shares. Contracts based on shares of Italy and UK – 1000 shares. Contracts based on shares of US – 100 shares
• Delivery months: Nearest two of March, June, September and December, plus nearest two serial months such that the nearest three calendar months are always available for trading

Contracts available (to August 14, 2003)

• Denmark:

Danske Bank A/S

Novo-Nordisk A/S

• Finland:

Nokia OYJ

• France:

Air Liquide SA

Alcatel SA

Aventis SA

Axa SA

BNP Paribas SA

Carrefour SA

Compagnie de Saint Gobain

France Telecom SA

Groupe Danone SA

L’Oréal SA

Lafarge SA

LVMH Moet Hennessy Louis Vuitton SA

Orange SA

Pinault-Printemps-Redoute SA

Sanofi-Synthelabo SA

Schneider Electric SA

Société Générale SA

Suez SA

Total Fina Elf SA

Vivendi Universal SA

• Germany:

Allianz AG

BASF AG

Bayer AG

Bayerische Hypo-und Vereinsbank AG

Bayerische Motoren Werke (BMW) AG

Commerzbank AG

DaimlerChrysler AG

Deutsche Bank AG

Deutsche Telekom AG

E.ON AG

Münchener Rückversicherungs Gesellschaft AG

RWE AG

SAP AG

Schering AG

Siemens AG

Volkswagen AG

• Italy:

Assicurazioni Generali SpA

Banca Intesa SpA

Enel SpA

Eni SpA

MediaSet SpA

Telecom Italia SpA (ex Olivetti SpA)

Riunione Adriatica di Sicurta SpA

San Paolo-IMI SpA

STMicroelectronics NV

Telecom Italia Mobile SpA

Telecom Italia SpA

UniCredito Italiano SpA

• Netherlands:

ABN AMRO Holdings NV

Aegon NV

Akzo Nobel NV

Fortis

ING Groep NV

oninklijke Ahold NV

Koninklijke Philips Electronics NV

Royal Dutch Petroleum Co

Unilever NV

• Norway:

Norsk Hydro ASA

• Spain:

Banco Bilbao Vizcaya Argentaria SA

Endesa SA

Iberdrola SA

Repsol YPF SA

Santander Central Hispano SA

Telefonica Moviles SA

Telefonica SA

Terra Networks

• Sweden:

Hennes & Mauritz AB

Nordea AB

Svenska Handelsbanken

Telefonaktiebolaget LM Ericsson

TeliaSonera AB

• Switzerland:

Credit Suisse Group

Nestle SA

Novartis

Roche Holding AG

Swiss Reinsurance AG

Swisscom AG

UBS AG

Zurich Financial Services AG

• UK:

Abbey National plc

AstraZeneca plc

Aviva plc

Barclays plc

BP plc

BT Group plc

Diageo plc

GlaxoSmithKline plc

GUS plc

HBOS

HSBC Holdings plc

Legal & General Group plc

Lloyds TSB Group plc

Marks & Spencer plc

mmO2 plc

Prudential plc

Royal Bank of Scotland Group plc

Sainsbury (J) plc

Shell Transport & Trading Co plc

Tesco plc

Unilever plc

Vodafone Group plc

• US:

Amgen Inc

AOL Time Warner Inc

Cisco Systems Inc

Exxon Mobil Corp

General Electric Company

IBM Corporation

Intel Corp

Merck & Co. Inc

Microsoft Corp

Pfizer Inc

Wal-Mart Stores Inc

Max Butti, product manager, universal stock futures, marketing, Euronext.liffe