Communication Services Select Sector Spinoff

Since two Select Sector Indices are splitting into three successor indices, there might not be a way to recapture the exact same exposure following the rebalancing. For example, if an investor only had the current Technology Select Sector but no Consumer Discretionary, he/she can only approximate by either leaving off the telecom exposure altogether or getting some additional exposure, formerly in the Consumer Discretionary.

If the decision is to leave out the telecom exposure, nothing needs to be done. The index rebalancing will take care of the issue automatically. Since the notional value of the exposure does not change at the rebalancing, it is tantamount to selling the telecom exposure and reinvesting in all the remaining information technology names. To approximate exposure to the initial underlying portfolio by incorporating some consumer discretionary names, position holders in the E-mini S&P Technology Select Sector futures⁴ would need to trade out of some Technology futures and into an equivalent amount of Communication Services futures, at the close on the rebalancing day or otherwise. The situation for investors in Consumer Discretionary Select Sector futures³ is analogous. If the investor had exposures in both sectors going into the rebalancing, the approximation would be closer. Trading out of the exposure in the Consumer Discretionary and Technology Select Sectors and into the Communication Services futures would do the trick.

By way of example, a 100-lot long position in both the Consumer Discretionary futures and Technology futures, the amount that needs to be transitioned is determined by each respective Select Sector’s portion of their previous index.

As previously stated, the Communication Services Select Sector has 16 constituents from the Consumer Discretionary Select Sector which equals approximately 20% of the weight of its former index. The seven constituents being pulled from Technology into Communication Services represent approximately 25% of the weight of its former index.

The index manager who is currently long 100 contracts in both the Technology futures and the Consumer Discretionary futures will need to rebalance their exposure on rebalancing day.

After the index manager does the correct analysis (shown below), he determines to gain the same exposure that he is currently carrying, he must sell 25 Technology futures and 20 Consumer Discretionary futures to remove the Communication Services exposure. Once the index manager has sold his shares in Technology and Consumer Discretionary Select Sectors, he must buy the equivalent exposure in the new Communication Services futures. He determines that he must go long 70 Communication Services futures contract to gain the correct exposure. He can accomplish this by utilizing the BTIC mechanism on trade date September 21.

Alternatively, an index manager may attempt to capitalize before the rebalancing event on September 21. The Communication Services futures contract will be available for trading on September 10, 2018, giving customers 10 trading days prior to the rebalancing of the index to transition their exposure to the index.

For investors managing assets benchmarked to any of the three Select Sector Indices affected by the rebalancing and receiving subscription and redemption flows in the run up to the reconstitution, it may be easier to use Select Sector futures to manage the equitization of those cash flows. This avoids the need to trade a cash basket which has potentially volatile underlying. Exchanging the basket for the equivalent Select Sector futures position prior to the rebalancing via an Exchange For Physical (EFP) trade would accomplish the purpose.

Investors whose mandate allows them to trade prior to the reconstruction day have discretion on the composition of the cash basket they trade for equitizing fund cash flows. They can attempt to benefit from the potential price movements of the stocks being added or deleted to the index and trade ahead of time.

To manage any notional discrepancy between the shifting stocks that an investor trades prior to the reconstruction, an investor can use E-mini Select Sector futures (specifically using the E-mini Communication Services Select Sector futures, E-mini Consumer Discretionary Select Sector futures and E-mini Technology Select Sector futures) as part of their core holding and easily manage their notional up and down as they trade around the positions.

1. Hereafter, E-mini S&P Communication Services Select Sector futures will be referred to as Communication Services futures in this piece.
2. A BTIC transaction enables market participants to execute a basis trade relative to the official close for the underlying index for more efficient cash management. For more information on BTIC, please follow this link.
3. Hereafter, E-mini S&P Consumer Discretionary Select Sector futures will be referred to as Consumer Discretionary futures
4. Hereafter, E-mini S&P Technology Select Sector futures will be referred to as Technology futures