Equity Investing.

Investors can access index performance through derivatives such as options, swaps, or futures contracts. These strategies are advantageous due to their low cost, ease of implementation, and provision of leverage. However, they also present risks, including counterparty default risk for derivatives not traded on exchanges or cleared through a clearing house. Derivatives can be relatively difficult for individual investors to access. For instance, an investor might use a futures contract on the S&P 500 Index to gain exposure to the performance of the index without having to buy all the individual stocks in the index.

Options, Swaps, and Futures Contracts

Options, swaps, and futures contracts are available on many major indexes, such as the MSCI EAFE Index and the S&P 500 Index. Options and futures are traded on exchanges and processed through a clearing house, which eliminates virtually all default risk. Equity swaps are generally executed with a single counterparty, adding the risk of default by that counterparty. For example, if an investor enters into an equity swap with a bank, and the bank goes bankrupt, the investor could lose their investment.

Leverage and Notional Value

Derivatives allow for leverage through their notional value amounts. The notional value of the contracts can be many times greater than the initial cash outlay. However, derivatives expire, whereas stocks can be held indefinitely. The risk of an expiring options contract is a complete loss of the relatively small premium paid to acquire the exposure. Futures and swaps can be extended by “rolling” the contract forward. For example, if an investor buys a futures contract on the S&P 500 Index with a notional value of $1 million, they might only have to put up $50,000 in initial margin, giving them a leverage ratio of 20:1.

Futures Commission Merchant (FCM)

Futures positions must be initiated with a futures commission merchant (FCM), a clearing house member assigned to trade on behalf of the investor. The FCM posts the initial margin required to open the position and then settles on a daily basis to comply with the maintenance margin required by the clearing house. The FCM also helps close the position upon expiration. For example, if an investor wants to buy a futures contract on the S&P 500 Index, they would need to open an account with an FCM, who would then execute the trade on their behalf.

Derivatives as Portfolio Overlays

In investment management, derivatives play a crucial role in modifying existing portfolios to better align with investment objectives, effectively acting as an overlay. One common application is the completion overlay, which is used when an indexed portfolio drifts from its target exposure. The completion overlay helps adjust the portfolio back to its intended alignment. Another essential overlay is the rebalancing overlay, which facilitates the adjustment of a portfolio by selling and buying specific securities to maintain its desired composition. Currency overlays are also employed to hedge against foreign exchange risk, converting the returns of foreign investments back to the portfolio manager’s home currency. For example, a portfolio manager managing a portfolio of European stocks may use a currency overlay to hedge the risk of euro fluctuation against the US dollar.

Advantages of Equity Index Derivatives

Equity index derivatives offer several advantages over cash-based portfolio construction approaches. They allow a portfolio manager to increase or decrease exposure to the entire index portfolio in a single transaction. Many derivatives contracts are highly liquid, sometimes more so than the underlying cash assets. However, strategic changes to portfolios are usually best made using cash instruments, which have indefinite expirations and do not necessitate rolling over expiring positions. For example, if a portfolio manager wants to increase their exposure to the S&P 500 Index, they could do so by buying a futures contract on the index, rather than buying all the individual stocks in the index. Equity index derivatives primarily include futures and swaps

Equity Index Futures

Equity index futures allow investors to gain exposure to a specific index. These contracts are distinct in that they are cash-settled, meaning that the transaction is completed with cash rather than the transfer of physical shares. The buyer of an equity index futures contract secures the right to purchase the underlying index at a predetermined price on the contract’s expiration date. This arrangement is based on the futures price established when the derivative was initially acquired.

Advantages of Equity Index Futures

Futures contracts require only a small margin upfront, offering significant leverage potential, which can amplify gains (or losses).

There are fewer constraints on initiating futures positions, including short sales, compared to some stock investments, providing flexibility for investors.

Equity index futures are characterized by high liquidity, evident through low bid-ask spreads, facilitating easier entry and exit from positions.

Low commission and execution costs relative to the level of market exposure achieved make futures an efficient tool for adjusting portfolio equity risk.

Disadvantages of Equity Index Futures

The primary drawback is the risk of basis risk, which occurs when the futures and the underlying index prices do not move in sync, potentially leading to imperfect tracking of the benchmark.

Basis risk can be exacerbated by dividends paid on the underlying securities, which are not captured by the futures contract that only tracks index price movements.

This discrepancy can be partially offset by holding interest-bearing securities alongside futures positions to mitigate the impact of basis risk.

Margin Requirements and Risks

Futures account holders must also post margin. The margin amount varies by trading exchange. For example, in the case of an S&P 500 futures contract, the initial margin required by the Chicago Mercantile Exchange for an overnight position is USD 6,600. The minimum maintenance margin for one contract is USD 5,400. If the contract unit value decreases by more than USD 1,200, a margin call will be triggered. This demonstrates how even a small change in the index value can result in a margin call once the mark-to-market process occurs.

Equity Index Swaps

Another derivatives-based approach is the use of equity index swaps. These are negotiated arrangements in which two counterparties agree to exchange cash flows in the future. For example, an investor with a USD 20 million notional amount may want to be paid the return on her benchmark index, the S&P 500, during the coming year. In exchange, the investor agrees to pay a floating rate of return of Market Reference Rate (MRR) + 0.20% per year, with settlement occurring semi-annually. The payment received by the portfolio manager is from the first leg of the swap, and the payment made by that manager is from the second leg.

Risks Associated with Equity Swaps

Equity swaps are subject to counterparty risk, where one party may default on their obligations.

They face liquidity risk due to their non-marketable nature, making it difficult to transfer the agreement to another party.

Interest rate risk affects the party responsible for payments linked to a floating interest rate (MRR), impacting the cost of the swap.

Swaps carry tax policy risk, as changes in tax legislation can affect the tax efficiency of swap agreements, which is often a motivation for their use.

Advantages of Equity Index Swaps

Equity swaps offer synthetic exposure to index returns, bypassing the limitations of exchange-traded futures that are only available for a select number of equity indexes.

They allow for customization in terms of the underlying index, settlement frequency, and maturity, offering flexibility to both parties.

Swaps can be negotiated for long durations, depending on the agreement between the counterparties.

Using a swap negates the need for transaction costs associated with purchasing all constituents of an index, making it a cost-effective strategy.

Like futures, swaps can be used to add leverage or hedge a portfolio on a tactical or short-term basis.

Equity index-based portfolios are a type of investment strategy where the portfolio is managed separately and is designed to replicate the performance of a specific index. This strategy requires a set of tools and resources to effectively manage the portfolio and ensure compliance with applicable laws and regulations. Let’s delve deeper into the requirements and tools needed for managing such portfolios.

Separately Managed Equity Index-Based Portfolios

Data Subscription

Data subscription can be acquired directly from the index provider and may be offered on a daily or less-frequent basis. For example, data for the FTSE 100 index can be obtained directly from the London Stock Exchange. The data are provided for analysis only and a separate license must be purchased for index replication strategies. This is similar to how a music streaming service might provide songs for listening but require a separate license for commercial use. The index subscription data should include company and security identifiers, weights, cash dividend, return, and corporate action information. This information is crucial for accurately replicating the index and tracking its performance.

Trading Systems

Trading systems allow the manager to see her portfolio and compare it to the chosen benchmark. For example, a manager using the Bloomberg Terminal can view her portfolio’s performance and compare it to the S&P 500 index. Common features of trading systems include electronic communication with multiple brokers and exchanges, an ability to record required information on holdings for taxable investors, and modeling tools so that a portfolio can be traded to match its benchmark.

Accounting Systems

Accounting systems should be able to report daily performance, record historical transactions, and produce statements. These systems are crucial for tracking the portfolio’s performance and ensuring accurate financial reporting. Portfolio managers rely heavily on their accounting systems and teams to help them understand the drivers of portfolio performance. For example, a manager might use the accounting system to identify which stocks are performing well and which are underperforming.

Broker Relationships

Broker relationships are an often-overlooked advantage of portfolio managers that can negotiate better commission rates. For example, a manager with a strong relationship with a broker might be able to negotiate a lower commission rate, thereby increasing the portfolio’s net returns. Commissions are a negative drag on a portfolio’s returns. The lower the commission rate, the higher the net return. The commission rates quoted to a manager can differ on the basis of the type of securities being traded, the size of the trade, and the magnitude of the relationship between the manager and broker.

Compliance Tools and Teams

Investors must adhere to a myriad of rules and regulations, which can come from client agreements and regulatory bodies. For example, a manager might need to comply with the SEC’s rules on insider trading and the client’s investment policy statement. Sanctions for violating compliance-related rules can range from losing a client to losing the registration to participate in the investment industry. This underscores the importance of having robust compliance systems and teams. Compliance rules can be company-wide or specific to an investor’s account. For example, a company might have a company-wide policy on ethical investing, while a specific client might have a policy against investing in tobacco companies.

Portfolio Management

Indexed portfolio managers must review their holdings and their weightings versus the index each day. This is crucial for ensuring that the portfolio accurately replicates the index and tracks its performance. To establish the portfolio, the manager creates a trading file and transmits the file to an executing broker, who buys the securities using a program trade. Program trading is a strategy of buying or selling many stocks simultaneously. Index portfolio managers may trade thousands of positions in a single trade file and are required to deliver the orders and execute the trades quickly. This is crucial for ensuring that the portfolio accurately replicates the index and tracks its performance.

Order Management System (OMS)

Portfolio managers use their OMS to model their portfolios against the index, decide which trades to execute, and transmit the orders. For example, a manager might use the OMS to decide to buy shares in Apple and sell shares in Microsoft to better match the S&P 500 index. Transmitting an order in the United States is generally done on a secure communication line, such as through FIX Protocol. International trading is usually communicated using a similar protocol through SWIFT.

Index-based Strategies

Index-based strategies seek to replicate an index that is priced at the close of business each day. For example, a manager might aim to replicate the performance of the S&P 500 index, which is priced at the close of the New York Stock Exchange each day. Most index-based trade executions take place at the close of the business day using market-on-close (MOC) orders. This is to ensure that the portfolio’s performance closely tracks the index’s performance.

Managers maintain the portfolio by trading any index changes, such as adds/deletes, rebalances, and reinvesting cash dividend payments. For example, if a company is added to the S&P 500 index, the manager would need to buy shares in that company to accurately replicate the index.

Best practice would be to review the portfolio’s performance each day and its composition at least once a month. This helps ensure that the portfolio continues to accurately replicate the index and track its performance.

Practice Questions

Question 1: A portfolio manager is considering the use of equity index derivatives to increase or decrease exposure to the entire index portfolio in a single transaction. Which of the following statements is true regarding the use of equity index derivatives and cash instruments?

1. Strategic changes to portfolios are usually best made using equity index derivatives, which have indefinite expirations and do not necessitate rolling over expiring positions.
2. Strategic changes to portfolios are usually best made using cash instruments, which have indefinite expirations and do not necessitate rolling over expiring positions.
3. Equity index derivatives and cash instruments both have indefinite expirations and do not necessitate rolling over expiring positions.

Answer: Choice B is correct.

Strategic changes to portfolios are usually best made using cash instruments, which have indefinite expirations and do not necessitate rolling over expiring positions. Cash instruments, such as stocks and bonds, do not have an expiration date and can be held indefinitely by the investor. This makes them ideal for strategic changes to portfolios, as they provide a long-term exposure to the underlying assets. Furthermore, cash instruments do not require the investor to roll over expiring positions, which can be a complex and costly process. This is particularly important for strategic changes, which are typically long-term in nature and require a stable and consistent exposure to the underlying assets. Therefore, while equity index derivatives can provide a quick and efficient way to adjust the exposure to an entire index portfolio, they are not typically the best choice for strategic changes due to their finite lifespan and the need to roll over expiring positions.

Choice A is incorrect. Equity index derivatives, such as futures and options, do not have indefinite expirations. They have a specific expiration date, after which they become worthless. This necessitates the rolling over of expiring positions, which can be a complex and costly process. Therefore, while equity index derivatives can provide a quick and efficient way to adjust the exposure to an entire index portfolio, they are not typically the best choice for strategic changes.

Choice C is incorrect. Equity index derivatives and cash instruments do not both have indefinite expirations. While cash instruments, such as stocks and bonds, do not have an expiration date, equity index derivatives, such as futures and options, do have a specific expiration date. This necessitates the rolling over of expiring positions, which can be a complex and costly process. Therefore, this statement is not true.

Question 2: A portfolio manager is considering using futures contracts to modify the equity risk exposure of their portfolio. Which of the following strategies could the portfolio manager use to partially mitigate this basis risk?

1. Combine the futures position with interest-bearing securities.
2. Invest in equity index swaps instead of futures contracts.
3. Decrease the amount of margin used in futures trading.

Answer: Choice A is correct.

The portfolio manager can partially mitigate basis risk by combining the futures position with interest-bearing securities. Basis risk arises when the futures contract and the underlying asset do not move in perfect synchrony. In the context of equity index futures, this can occur when the underlying securities pay dividends, while the futures contract tracks only the price of the underlying index. By combining the futures position with interest-bearing securities, the portfolio manager can earn interest income that can help offset the loss of dividend income. This strategy can help reduce the basis risk associated with futures trading. It is important to note that this strategy does not eliminate basis risk entirely, but it can help to mitigate it. The effectiveness of this strategy will depend on the interest rate environment and the specific characteristics of the interest-bearing securities and the futures contract.

Choice B is incorrect. Investing in equity index swaps instead of futures contracts is not a strategy to mitigate basis risk. While swaps can be used to manage risk, they are not a direct substitute for futures contracts and do not address the specific issue of basis risk associated with futures trading. Swaps involve exchanging cash flows, not underlying assets, and therefore do not provide a direct hedge against changes in the price of the underlying asset.

Choice C is incorrect. Decreasing the amount of margin used in futures trading does not mitigate basis risk. Margin is a form of collateral used to secure a position in futures trading. While reducing margin can decrease the potential for margin calls and reduce the financial risk associated with futures trading, it does not address the issue of basis risk. Basis risk is related to the relationship between the futures contract and the underlying asset, not the amount of margin used in trading.

Glossary:

• Futures Trading: A financial strategy involving the buying and selling of futures contracts.
• Margin: The amount of money required in your account to maintain your market positions.
• Basis Risk: The risk that the futures price might not move in normal, steady relation to the underlying instrument.
• Equity Index Swaps: A derivative used to transfer both the credit risk and market risk of an underlying asset.
• Counterparty Risk: The risk to each party of a contract that the counterparty will not live up to its contractual obligations.
• Liquidity Risk: The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.
• Derivatives: Financial instruments whose value is derived from the value of another asset, such as a stock, bond, or index.
• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date.
• Swaps: Contracts in which two parties agree to exchange cash flows or other variables associated with different investments.
• Futures: Contracts that obligate the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
• Notional Value: The total value of a leveraged position’s assets. This term is commonly used in the options, futures, and currency markets.
• Futures Commission Merchant (FCM): An individual or organization that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support such orders.
• Portfolio Overlays: The use of derivatives to alter the risk profile of a portfolio, without changing the underlying asset allocation.
• Data Subscription: A service where an investor subscribes to receive data about an index and its constituents.
• Trading System: A system that allows investors to place trades and monitor their portfolio.
• Accounting System: A system that records financial transactions and generates financial reports.
• Broker: An individual or firm that acts as an intermediary between an investor and a securities exchange.
• Compliance: Adherence to laws, regulations, and standards.
• Program Trade: A strategy of buying or selling many stocks simultaneously.
• Order Management System (OMS): A system that facilitates and manages the execution of trade orders.
• Market-on-Close (MOC) Orders: A type of order to buy or sell a security at the closing price of the day.

Portfolio Management Pathway Volume 1: Learning Module 1: Index-Based Equity Strategies;LOS 1(c): Compare different approaches to index-based equity investing