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:
In this example, the S&P 500 is trading at 4250 and Russell 2000 at 2300 to begin the quarter:
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.
|Sell||380||S&P 500||3700 Put||$31.50||$598,500|
|Sell||300||S&P 500||4700 Call||$1.55||$23,250|
Premiums are illustrative estimates and will vary based on strike price, underlying price, time to maturity and implied volatility levels.
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.
All data sourced from CME Group.
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This case study was originally sourced from the following Tabb Group article.