Executive Summary
Life has returned to normal for hedge funds: funds are re-flowing, alpha is the theme, performance is up, and they are now charting their course for new and exciting markets.
While emerging markets present attractive opportunities in terms of risk arbitrage, they also come with hazards. They are notoriously difficult to access and there are barriers to entry in terms of local customs, language and overall street wisdom. Amongst other things, emerging market equities entail exposure to turbulent local currencies, discriminatory tax and capital controls, |
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restrictions on shorting, and immature clearing and settlement systems. Hedge funds are therefore increasingly using equity swaps, which allow them to participate in the performance of an emerging market stock without actually owning it.
At the same time as seeking access to new markets, hedge funds are also adopting new fund mandates, such as those stipulated under Europe’s UCITS III. Driven by a desire to broaden their investor base as well as potential new European hedge fund regulation, hedge funds are being increasingly funneled into retail-friendly and regulatory-compliant UCITS III structures. Such funds allow for the use of certain derivatives but do not allow for the physical shorting of shares, making equity swaps a critical tool for hedge funds.
Meanwhile, hedge fund relationships with prime brokers are evolving. Small- and medium-sized hedge funds are seeking out low cost alternatives to traditional prime brokers and, for the larger hedge funds looking to multi-prime, synthetic specialists can help them diversify away from their exclusive arrangements with large, one-stop-shop firms.
But while equity swaps are helping hedge funds access restrictive emerging markets, it could be regulation in the developed markets that hampers their ability to use the instruments. The new financial reform bill in the US is threatening the way banks deliver derivatives services and could raise the cost of services.
The TABB Group Vision Note The Alternative Emerging Market: Equity Swaps and Synthetic Prime looks at how equity swaps are providing opportunities for hedge funds in light of new investment mandates and regulatory obligations as they look for alpha in the emerging markets.