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22 July 2021

Case study: Maintain a fund’s mandated asset allocation ratio through shifting markets

By CME Group

CLIENT:

Fund/portfolio managers

CHALLENGE:

Efficiently maintain a fund’s asset ratio in changing markets

SOLUTION:

Short Equity Index options on futures trades

Overview:

A portfolio manager with a $2 billion portfolio has a mandate to maintain a 60/40 mix (60% equities to 40% fixed income). Within the 60% equities allocation ($1.2 billion), the manager must maintain a 50/50 mix of large-cap equities benchmarked to the S&P 500 and small-cap equities benchmarked to the Russell 2000.

The portfolio is set up with this ratio, but later market movements could shift portfolio weightings out of line with the desired exposure.

Options on futures are well designed to make asset allocation ratios easier to maintain/manage and, at the same time, potentially enhance portfolio returns.

Approach:

At the beginning of each quarter, the portfolio manager can sell out-of-the-money calls and puts on both E-mini S&P 500 and E-mini Russell 2000 options on futures, at strike prices that match the level where the manager would need to materially rebalance their portfolio.

The portfolio will receive income on selling these options but will also lock in price levels where they will increase or decrease stock market exposure.

For a $1.2 billion equity allocation of a 50/50 mix of large to small caps:

  • Sell calls and puts based on $600 million of value for the S&P 500
  • Sell calls and puts based on $600 million of value for the Russell 2000

In this example, the S&P 500 is trading at 4250 and Russell 2000 at 2300 to begin the quarter:

  • For the S&P 500 large-cap exposure, positions would be increased with the index below 3750 and decreased with the S&P 500 over 4750.
  • For the Russell 2000 small-cap exposure, positions would be increased if the Russell 2000 is below 2000 and decreased with the Russell 2000 over 2600.

Results:

The number of options used to rebalance the portfolio is based on the strike price times the $50 multiplier for both the E-mini S&P 500 and E-mini Russell 2000 futures combined with the respective index levels.  In this example, the following transactions would be used to bring the respective weightings back in line with the portfolio’s mandate.

Short options trades

Action Contracts Underlying Option Premium Dollar Income
Sell 380 S&P 500 3700 Put $31.50 $598,500
Sell 300 S&P 500 4700 Call $1.55 $23,250
Sell 780 Russell 1900 Put $21.10 $822,900
Sell 600 Russell 2500 Call $6.40 $192,000
           
        Income $1,636,650

Premiums are illustrative estimates and will vary based on strike price, underlying price, time to maturity and implied volatility levels. 

Conclusion:

The portfolio manager can maintain the fund mandated equities ratio without costly transactions of portfolio holdings by using short E-mini options positions – and add income.

>$1.6 million

Amount of option income added to the portfolio by using short options on futures to maintain the equity mix. 

$1.2 billion

Dollar value of the 60% equity exposure allocation maintained through short options positions.

2,060

Number of short E-mini options positions used to maintain the desired 50/50 mix of large-cap/small-cap equities exposure.

All data sourced from CME Group.

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equities@cmegroup.com

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This case study was originally sourced from the following Tabb Group article.