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.

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

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.

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

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

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