Johannesburg, 07 June 2012

Craig Massey, Alwyn van der Merwe

Despite some highly publicised international trading disasters, derivative instruments are not as controversial as they are made out to be and have a very definite place in South African portfolio management.

This is the view of Craig Massey, director of Stockbroking at Sanlam Private Investments (SPI), who was speaking at an SPI quarterly briefing session held at Johannesburg's Hyatt Hotel today.

"The spread and sophistication of derivative instruments has huge potential for growth in South Africa. We are already vying with India as the biggest user of single stock futures in the world," he said, adding that local investors are now able to buy into major international companies not listed on the JSE through investing in IDX single stock futures.

While the use of derivatives has been tainted by highly publicised losses generated by traders such as Nick Leeson, who brought down Barings Bank in 1995, and more recently multi-billion dollar fallouts at Societe Generale and JP Morgan, Massey stresses that these incidences were the result of fundamental trading protocols and management systems being breached or abused amid the lack of proper monitoring and controls being in place.

"If they are understood and used correctly, derivative instruments are no more risky than buying underlying assets. However, due to the leverage factor, if investors get it wrong, they can get it many times wrong," added Massey, saying that regulations have been introduced in the US to separate financial institutions' proprietary trading business from their commercial activities to quarantine "the man in the street's deposits."

According to Massey, derivatives are essentially used for three different purposes - outright speculation, hedging/protection against uncertainty, and to enhance returns by utilising option strategies.

He believes that derivative instruments will play an increasingly important role in portfolio management in South African financial markets as more investors seek to take advantage of leveraging opportunities.

"Huge advances in computer trading have enabled traders and investors to design their own tolerance levels and get computers to then do the work for them. Trading can be done extremely quickly with very thin margins," said Massey, adding that opportunities for arbitrage have also been greatly increased.

In addition, he said, derivative instruments enable investors to lock in current values of underlying assets, retain strategic holdings and hedge positions in illiquid stocks.

In the options arena, Massey said options provided company directors, for example, with a means to use  "zero cost collar" structures to protect themselves against downside exposure to underlying stocks while giving away some of the upside.

Meanwhile, commenting on the current investment outlook, Alwyn van der Merwe, director of Investments at SPI, said there was an important role for derivatives to play in an uncertain international investment environment.

"The four major potholes that we flagged in the first quarter are still very much in play - namely the ongoing meltdown in Europe, the slowdown in the US, the possibility of a hard landing in China and geo-political instability in the Middle East," he said.

"Europe remains the biggest challenge, with the Greeks going to the polls on 17 June. While many commentators are predicting a break-up of the Eurozone, this is by no means definite as Germany, the region's powerhouse economy, needs Europe and the Euro."

Van der Merwe said that while Middle East tensions remained a major uncertainty, especially the ongoing unrest in Syria. The fall in the oil price to under US$100 a barrel reflects concerns regarding the demand for oil against a backdrop of slowing global activity.

Commenting on traditional stock portfolios going forward, he said there is a need for "smart portfolio crafting" in an environment that is "still extremely fluid." However, said van der Merwe, "pockets of value are emerging".

He said that four out of five of Sanlam's stock picks in the first quarter - Capitec, MTN, Naspers and British American Tobacco - had performed well, while Anglo American had disappointed.

While the four solid performers might continue to perform, investors may need to consider changing "tyres" if the "road" changes. Anglo American could be a strong performer if the current bearish sentiment changes on positive macro-economic surprises.

distributed by