Dealers in the U.S. have been structuring simple bespoke baskets of equity stocks for institutional clients that look like exchange-traded funds. The idea is to improve upon popular ETFs by tailoring the baskets to individual managers' portfolios, while aiming for similar liquidity benefits as offered by ETFs.
The managers are interested in using options on ETFs as a hedge for equity portfolios, explained one institutional salesman at a U.S. firm in New York. The difficulty for equity portfolio managers, however, is that while some ETFs seem to give broad and even exposure to an equity sector, the underlying index weightings may make them inappropriate as a hedge. The salesman used an ETF linked to a sub-index of retail stocks as an example. A retail-stock focused fund may want to buy an option on the ETF as a hedge, but the ETF may be substantially weighted toward a handful of corporates with the largest market capitalization. A custom-made basket could avoid this weighting drawback.
While the strategy is not rocket science, said a structurer at another U.S. firm, it shows that institutional managers are getting more comfortable with derivative-based structures. "The never-ending search for alpha has also led them into this," he added. Officials declined to name any managers who have entered such trades.
