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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 and consider scenarios where there is a 12% move of each index in either direction:

  • For the S&P 500 large-cap exposure, positions would be increased with the index below 3740 and decreased with the S&P 500 over 4760.
  • For the Russell 2000 small-cap exposure, positions would be increased if the Russell 2000 is below 2024 and decreased with the Russell 2000 over 2576.
  • For simplicity, the value of the fixed income portion of the portfolio is assumed constant for the observed period

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. The number of options used is also dependent on the 60/40 equities and fixed income mandate of the portfolio. In this example, the following transactions would be used to bring the respective weightings back in line with the portfolio’s mandate for both the large and small-cap weightings as well as the equity and fixed income weightings.

Short options trades

Action Contracts Underlying Option Premium Dollar Income
Sell 154 S&P 500 3750 Put $31.50 $242,550
Sell 121 S&P 500 4700 Call $1.55 $9,378
Sell 288 Russell 2000 Put $21.10 $303,840
Sell 222 Russell 2600 Call $6.40 $71,040
        Income $626,808

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 ratios without costly transactions of portfolio holdings by using short E-mini options positions – and add income.

>$600K

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

$1.28 to 1.05 billion

Range of dollar value of the 60% equity exposure allocation maintained through short options positions following allocation to maintain mandate 60/40 equity/fixed income ratio.

785

Number of short E-mini options positions used to maintain the desired 50/50 mix of large cap/small cap equities exposure and 60/40 equity/fixed income ratio.

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.


This material is directed only at, persons who are: (i) investment professionals (as that term is defined in article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (“FPO”)), (ii) high net worth companies (as that term is defined in article 49 of the FPO) or (iii) any other persons to whom it may lawfully be communicated. Accordingly, persons who (i) do not have professional experience in matters relating to investments or (ii) are not high net worth companies, should not act or rely on this material. The financial instruments and / or services detailed in this material will only be available to high net worth companies or investment professionals (as defined above). If you are not a high net worth company or investment professional (as defined above) you cannot invest directly and are unable to gain access to the relevant financial instruments. CME GROUP DOES NOT REPRESENT THAT ANY MATERIAL OR INFORMATION CONTAINED HEREIN IS APPROPRIATE FOR USE OR PERMITTED IN ANY JURISDICTION OR COUNTRY WHERE SUCH USE OR DISTRIBUTION WOULD BE CONTRARY TO ANY APPLICABLE LAW OR REGULATION.