TABB Says Equity Swaps Are Critical Tool for Hedge Funds Accessing Emerging Markets

Trading in Emerging Market Equity Swaps Forecast to Rise at 22% CAGR by 2011 as Funds Turn to Synthetics over Cash Equities

Prime Brokers Compete for New Business Based on UCITS III Launches and Hedge Funds’ New Emerging Market Investment Strategies

LONDON & NEW YORK--(BUSINESS WIRE)-- Hungry for alpha, hedge funds are turning to equity swaps and synthetic prime to access emerging markets offering attractive spreads and easily identifiable risk arbitrage opportunities. According to forecasts by TABB Group in a new research report, “The Alternative Emerging Market: Equity Swaps and Synthetic Prime,” trading in emerging market equity swaps is forecast to rise at a compound annual growth rate (CAGR) of 22% by 2011, reaching US$330 billion in outstanding notional amounts as funds turn to synthetic solutions over cash equities. During this same period, TABB expects developed market equity swaps to grow at a CAGR of 15%, totaling US$2.1 trillion.

While emerging markets present attractive opportunities in terms of risk arbitrage, says Will Rhode, a research analyst at TABB and author of the new report, investment hazards loom: exposure to turbulent currencies; discriminatory tax and capital controls; cumbersome and expensive local red tape for local securities trading; unreliable technical and telecommunication infrastructure; and immature clearing and settlement systems.

Driven by the need to broaden their investor base as well as take advantage of potential new European hedge fund regulation, Rhode explains that hedge fund investments are being increasingly funneled into retail-friendly and regulatory-compliant UCITS III structures, funds that allow for the use of certain derivatives but not for the physical shorting of shares, making equity swaps a critical if not a potentially attractive tool for portfolio managers. According to TABB, the UCITS III market is expected to grow at a CAGR of 13%, totaling US$9.6 trillion by 2012.

Hedge fund managers tell TABB that they are converting their cash equity positions into swaps to mitigate concerns over a new international accounting standard known as FIN 48 that requires funds to reflect uncertain tax regimes in their net asset value (NAV). “The jury is still out on whether this investment strategy will be successful and this, plus the HIRE Act, which allows tax authorities worldwide to hunt down and prosecute firms using synthetics to bypass withholding tax of US share dividends, may well dampen enthusiasm among prime brokers if they suspect the investment is purely for tax purposes.”

Eager to compete for this new business, prime brokers have been aggressively targeting hedge fund demand for equity swaps. However, the shake-up in the prime broker landscape since late 2008 means there is far greater choice and competition. Away from the large one-stop brokerage, small specialist prime brokers are beginning to offer high-touch, low-cost, service-oriented solutions. “Pure synthetic prime brokers, for example, are able to offer a low-cost alternative to small- and medium-sized hedge funds as well as to those larger funds seeking affordable multi-prime models,” says Rhode

But there are challenges ahead, he cautions. “Hedge funds are driven by a desire to understand risk in order to maximise return. While equity swaps are proving to be a flavour of choice in this regard, they will need to tread carefully when it comes to managing the most unquantifiable and difficult to evaluate risk of all, that of regulation.”

The 27-page report with 12 exhibits is available now for download by TABB Group Research Alliance Derivatives clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.

Other recent TABB European and related derivatives research includes: Decisions in the Dark: Aligning Results with Expectations in European Equities; Trading in the Dark in Europe: Choice and Complexity on the Cusp of Change; Effective Spreads in European Equities: A TABB Group Pinpoint; Post-MiFID Market Surveillance: New Obligations and Opportunities; and European Equity Trading 2009: Counterparties, Capital and Control.

About TABB Group

TABB Group is the financial markets industry’s only research and strategic advisory firm focused exclusively on capital markets, with offices in New York and London. Founded in 2003 and based on the proven interview-based research methodology of “first-person knowledge” developed by founder Larry Tabb, TABB Group analyzes and quantifies the investing value chain from the fiduciary, investment manager and broker, to exchange and custodian, helping senior business leaders gain a truer understanding of financial markets issues. In January 2010, TABB Group launched TabbFORUM, www.tabbforum.com, the by-invitation, online community where capital markets professionals share and contribute commentary on current industry-wide issues. For more information, visit www.tabbgroup.com.

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