Regulation: FSA queries derivatives use

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By:
Peter Koh
Published on:

The UK Financial Services Authority has questioned the spread of derivatives-based trading strategies, such as 130/30, by traditional long-only managers. The increasing use of derivatives poses a "range of risks", warns the FSA.

The regulator, which along with other UK regulators was heavily criticized for its handling of the crisis at Northern Rock, says there is a risk that managers could start using derivatives before appropriate middle-office and back-office systems and controls for risk management and compliance monitoring are developed. In its 2008 Financial Risk Outlook, published in February, the FSA says there is a risk that asset managers and clients will not be sufficiently aware of how using derivatives changes the risk characteristics of their portfolios by, for example, introducing implicit leverage, which has to be monitored against mandate restrictions.

"Using over-the-counter derivatives also introduces the need to manage counterparty risk through suitable collateralization arrangements," adds the FSA.

The FSA highlights the fact that new styles of investing, such as 130/30 funds or unconstrained equity funds, have increased in popularity, to the extent that some of these products are entering the retail market after having been established for some time among institutional investors. "It is questionable whether all asset managers have the appropriate systems and skills to manage and control the wide range of new products available to a consistently high standard," says the FSA, adding that the new areas involve "the use of skills that are in short supply and require asset managers to compete with banks, hedge funds and each other for talent".

F&C Investments Enhanced Alpha UK Equity Fund, launched in August, was the first 130/30 from a big asset management house to focus on UK equities. Its managers report outperformance against the FTSE All-Share Index of 4.21% during the fund’s first six months of trading. The fund manager says it has advanced risk management systems that enable its managers to view live positions and undertake pre-trade risk analysis for both long and short positions. Commenting on the implementation of its long/short strategy, Richard Wilson, the firm’s head of equities, says: "We are very pleased with the way this structure has worked for UK equities as it underlines our credentials for managing this type of product. It is our intention to launch similar products across other equities desks where we have the demonstrable ability to do so."

A 130/30 fund uses a type of long/short strategy that involves balancing a gross long position of 130% of assets invested with a 30% short position. By relaxing the long-only constraint to a limited extent, the 130/30 manager hopes to gain additional upside by betting on negative views on stocks as well as positive ones. An unconstrained equity fund, meanwhile, has fewer limits on portfolio construction than a fund that is traditionally limited to having exposures set within a narrow band relative to an index. Competition from hedge funds and the introduction of Ucits III has encouraged a number of asset managers that are traditionally long-only to establish 130/30 and other types of funds that encroach on alternative investments. Ucits III lets asset managers go short but it does not permit physically going short, which means managers are restricted to putting their short positions on synthetically, using derivatives.