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March 1, 2003

A Goldmine in Europe?

By Kevin Pilarski

For some traders in the U.S., Europe's bourses have never looked so promising. Volatility, deep liquidity, diversification and attractive returns in Europe are a great incentive. The rise of the Euro is also fuelling a strong U.S. interest.

This Euro zone is home to a hot group of products: European index-based investments. These indexes, which measure stock performance across the zone, include the Dow Jones STOXX, MSCI, FTSE and S&P.

Today Dow Jones EURO STOXX 50 futures and options listed on the Eurex exchange, are the world's second largest equity index derivatives contract. They had aggregate open interest of EUR 235 billion at the end of last year. By some estimates, 25 to 40 percent of DJ EURO STOXX 50 futures volume originates in the U.S. That's up from less than 10 percent - only two years ago.

Here are some strategies associated with these products:

* Global Macro: Traders use this strategy to profit from long or short positions, often using broad based index futures. Positions reflect views on overall global market trends. They can often be implemented most simply and efficiently using exchange-traded index derivatives.

* Equity Market Neutral: This strategy exploits market inefficiencies involving simultaneous long and short equity portfolios designed to be beta neutral. Equity index futures and options are used frequently to efficiently leverage or neutralize elements of the portfolio in volatile markets.

* Long-Short Equity: Used typically as directional equity trading involving both the long and short sides of the market. Traders can benefit from pairs trading strategies, industry versus individual company sector plays, and tactical asset allocation using sector over-weights. In this strategy, equity index sector futures, or ETFs, can efficiently provide the desired exposure.

In April 2000, the first exchange traded funds were launched in Europe by Merrill Lynch. These products, called LDRS, were based on the STOXX 50 (Pan-Europe) and Euro-STOXX 50 (Euro zone) blue-chip indexes. The growth in this category accounts for some $10.5 billion in assets under management in European ETFs. ETFs, based on Pan-European and Euro-zone indexes, have most of the market share in Europe. Six out of 10 of the top ETFs in Europe, measured by assets and turnover, are based on the S&P Europe 350, MSCI Pan-Euro, DJ STOXX 50, and DJ EURO STOXX 50 indexes.

Europe can be accessed in U.S. dollars with ETFs based on the pan-European and Euro zone markets. The iShares MSCI EMU, and the iShares S&P Europe 350 are available at the American Stock Exchange.

Euroclear France has established an automated processing service for ETF transactions in the primary market. Euroclear contends that the processing of these ETFs will reduce operational costs .

Meanwhile, the S&P Europe 350, which measures the performance of pan-European equities, recently had average daily volume of 97,500 shares on assets of about $400 million. The MSCI EMU, which measures equity market performance within the Euro-zone, has close to $136 million in assets since its inception. It is averaging daily volume of approximately 30,000 shares year-to-date.

Last October, in conjunction with UBS, the Fresco DJ STOXX 50 and Fresco DJ EURO STOXX 50 ETFs were launched at the NYSE, marking the Big Board's first major step into this market. Now, a basket of Europe's most liquid stocks are available to U.S. investors.

With an expense ratio of only 30 basis points and tight bid-ask spreads, it is not a surprise that these vehicles have taken off. In the first three months of trading, combined assets under management of the Fresco products increased by 29 percent, reaching $230 million at year-end 2002. So I expect the interest in index-based investments to grow as U.S. investors continue to watch Europe.

Kevin Pilarski is director, global derivatives, DJ STOXX and is based in Chicago.