Historically investment funds were tightly restricted in their use of derivatives,
but the introduction of UCITS III has given the managers more scope to take advantage of these powerful instruments.

Many now routinely hold contracts for difference (CFDs) in their portfolios and growing numbers of private investors are following their lead by opening a CFD account for themselves.

CFDs are cash-settled derivatives based on an underlying asset, such as a share or market index. In essence, they provide a versatile yet indirect exposure to the relevant price movement.

‘CFDs won’t offer much of an advantage for longer-term investors who may be looking to buy and hold a share for months on end, but they can be exciting for shorter-term traders looking to profit from the volatility,’ says Martin Slaney, head of derivatives at GFT Global Markets.

CFDs have experienced tremendous growth since they first became available to retail investors in the late 1990s. Active traders in particular have been quick to appreciate the benefits and many now prefer them to dealing direct in the underlying equities.

The long and the short of it
One of the main reasons that fund managers are turning to CFDs is that they allow them to take synthetic short positions – aiming to sell assets high and then buying back when they are cheaper – so as to profit from falling prices.

The fund that makes most use of the facility to sell short is BlackRock UK Absolute Alpha. This aims to achieve positive returns in all market conditions and has successfully done so in every quarter since it was launched over three years ago and, significantly, in each month since the emergence of the credit crisis last July. After subtracting the synthetic short exposures from the long positions the fund recently had a net exposure to the market of just 1.8 per cent.

Nick Osborne, who co-manages BlackRock UK Absolute Alpha alongside Mark Lyttleton, says that having the ability to short allows them to express their views more efficiently and with greater clarity. ‘We have been particularly cautious on companies that are exposed to changes in consumer discretionary expenditure and which have inappropriate financial structures given the difficulties in credit markets.’

Pairing up
The downside to shorting is that it entails a high degree of risk – there is no theoretical limit to how much a share price can rise, and therefore no limit to what you could lose.
One way to get round this is to use a pairs trade, which involves finding two stocks in the same sector where the returns are expected to differ and going long of one and short of the other. The combined position would then be both market and sector neutral and would only depend on the relative performance for its outcome.

‘If someone thought that HSBC was cheap compared to Standard Chartered, they could use CFDs to go long HSBC and short Standard Chartered in equal amounts,’ says Kareem Khouri, managing director of the capital division of brokers Killik and Co.

‘As long as they were correct in their belief that HSBC would outperform Standard Chartered, it would then be possible to make a profit irrespective of the direction of the market.’

New approaches
One relatively new type of fund that relies on CFDs is the 130/30 fund. These maintain a net 100 per cent exposure to the market, but can go up to a 130 per cent on the long side while holding up to 30 per cent of the portfolio in shorts. This gives the manager the scope to invest more in his favoured stocks, while also short selling those shares that he thinks will fall in value.

There are currently around half a dozen of these funds in the UK but there are many more in the pipeline. One that has found favour with independent advisers is Resolution International Cartesian UK Equity 130/30. The big plus with this fund is that the managers have extensive experience of running a hedge fund, which means they are well versed in the practice of shorting stocks.

One of the most innovative products to use CFDs is Skandia UK Strategic Best Ideas. This offers a long-short portfolio within the framework of a multi-manager fund. The way it works is that ten top investment managers are each asked to select ten UK shares and up to five of these can be short positions. This allows each of them the freedom to move from a 100 per cent exposure to fully market neutral. The selections are then combined into a 100 stock portfolio.

At time of writing, Skandia UK Strategic Best Ideas had 71 per cent of its portfolio invested in 58 different long stocks, 17 per cent spread across 20 shorts and 12 per cent in cash, giving it a net exposure to the market of 54 per cent. The fund has made a positive return since it was launched late last year despite the heavy falls in the markets.

Taking advantage of market volatility
‘Private investors are becoming more comfortable with the idea of using leveraged instruments like CFDs to make money from short-term price movements,’ says Ben Jeffreys, global product manager at Saxo Bank. ‘One way they can do this is to take a view on a forthcoming economic announcement or on a company ahead of its results.’
CFDs are traded on margin, which means an investor can open a much bigger exposure than the funds in their account would normally allow. This has the effect of magnifying the potential profits and losses that they can achieve with their capital.

‘If someone bought £10,000 of Vodafone shares this would normally cost £10,000 plus costs. But the same exposure using a CFD would be possible with a deposit of just £500, yet it would still be subject to the same price movements,’ says David Jones, chief market strategist at IG Index, sister company to CFD provider IG Markets.

An investor with a substantial share portfolio who was concerned about the short-term outlook could short an index CFD like that based on the FTSE 100 to act as a hedge.

‘Traditionally investors would either have to ride out the storm or sell their holdings and try and time their re-entry into the market,’ says Jeffreys. ‘With an index CFD they could sell short so that even if their stocks fell in value the CFD would make a profit to cover the loss. We even allow clients to use their stock portfolio as collateral to meet the margin requirements.’

Applying the brakes
‘CFDs allow investors to be far more flexible with their orders than when trading the shares direct,’ says James Hughes, analyst at CMC Markets. ‘In particular, they can use stops and limits to automatically get into and out of the markets when the price hits the levels they specify.’

David Jones feels that ‘Given the current market volatility, CFD traders should also maybe consider using a guaranteed stop. For example, when M&S issued a poor trading statement in July the shares opened 20 per cent lower than their previous day’s close. A stop would have cut in at the first tradable price, whereas a guaranteed stop would have taken effect at whatever level the investor had specified.’

Those concerned about this could open a limited risk CFD account like those available from IG Markets and CMC Markets. With these, every trade has to have a guaranteed stop and there must be enough cash to fund the worst-case potential loss.