Managing an Equity Index Reconstitution

Many indices process reconstitutions as part of their published index methodology. This process can occur at set periods or can even occur as part of an extraordinary event requiring the index to reconstitute outside of its published schedule. This allows the different indices to remain representative of the benchmarks they are targeting.

Why is this important for an investor?

The reconstitution can create risks for investors who are tracking these indices with a physical basket of stocks. They would like to ensure they have minimal slippage vs. their benchmark index and attempt to perfectly replicate the reconstitution. Similarly, it can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution.

How can CME Equity Index futures help investors around the reconstitution?

There are several scenarios in which the use of CME Equity Index futures, such as E-mini S&P 500 or E-mini Russell 2000, can help to mitigate risk for those investors tracking the related index and aid investors who are seeking to benefit from price movements of relevant US equities, as described below.

1. Investors tracking the index, trading solely on the reconstitution day

Investors who are tracking the index from a long perspective will often hold physical shares in the correct proportions prior to the reconstitution. To eliminate tracking error vs. the index, the investor must buy all the additions to the index and sell all the deletions on the cash close of the reconstitution day. Furthermore, each stock which remains in the index is likely to change its percentage weight higher or lower and this change in weight needs to be replicated by the investor’s share hedge. Operationally, this means an investor must typically trade hundreds of stocks or even thousands in the case of a very broad index such as Russell 2000. The investor needs to ensure they trade the exact quantity of shares correctly for each individual name. This can be challenging and is susceptible to operational error, which in turn creates tracking error.

The same principle holds true for clients who have short positions, with the added complication that an investor must source all the relevant locates to short each individual name that remains within the index.

Rather than having to execute this trade across hundreds or potentially thousands of individual names, an investor could simply hold a futures contract such as the CME E-mini S&P 500 Index futures contract in lieu of stock. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves. This task has effectively been outsourced to others. The futures contract will track the index and there will be no tracking error incurred by trying to replicate the reconstitution unsuccessfully.

To gain exposure to a CME Equity Index futures, a client may consider two main options:

  1. They can execute an exchange for physical (EFP) which allows them to exchange their portfolio of shares tracking the index for a CME Equity Index futures contract, and then carry the resultant futures contract across reconstitution (post reconstitution, the client can than execute another EFP to move their exposure back to a portfolio of shares should they wish).1
  2. They can execute a BTIC (Basis Trade at Index Close) transaction in one direction and trade out of their relevant share portfolio on the close of the cash index. BTIC can allow an investor to strike a futures off the cash index price. By buying CME E-mini Russell 2000 Index futures via a BTIC transaction and selling a cash portfolio on the close an investor is replacing their stock position with futures. Conversely, a short investor can do the opposite trade – sell CME E-mini Russell 2000 Index futures via a BTIC transaction and buy their share portfolio on the cash close. This strategy can be deployed in advance of the reconstitution and can also be averaged over several trading sessions based on execution and market impact preferences.2

Please note for the majority of CME Equity Index futures, BTIC transactions are available both on CME Globex or as a block trade.3

For more details on BTIC and how it works please see http://www.cmegroup.com/trading/equity-index/btic-transactions.html.

2. Managing fund flows prior to the reconstitution

For investors who are managing assets benchmarked to a certain index and who receive subscription and redemption flows in the run up to the reconstitution, it may be easier to use CME Equity index futures to manage the equitization of those cash flows. This avoids the need to trade a cash basket which has potentially volatile underlying. CME Equity Index futures can be traded on CME Globex or, if flows are tied to the close can be achieved by executing a BTIC transaction.

3. Investors tracking the index, trade prior to the reconstitution day

Investors whose mandate allows them to trade prior to the reconstitution 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 additions and deletions stocks that an investor trades prior to the reconstitution, the investor can use CME Equity Index futures as part of their core holding and easily risk manage their notional up and down as they trade around the add/delete positions.

4. Investors seeking to trade the potential price movements of the adds/deletes

These investors typically predict ahead of time the additions and deletions to a given index and manage these positions in the run up to the constitution becoming formalised. It can often be better from a risk management perspective to isolate the additions vs. a benchmark and similarly the deletions vs. a benchmark. It is often not ideal to manage additions vs. deletions solely via outright trades in the underlying stocks. The benchmark that can be used vs. either the additions or deletions are often available as a CME Equity Index futures and from a liquidity, ease of execution, capital and transparency perspective is often best implemented by using these futures. The futures can be executed intraday to risk manage notional positions around the adds or deletes cash baskets and can also be used targeting the cash close via a BTIC transaction.

5. Managing liquidity in less liquid names

Intraday liquidity in small caps tends to be much thinner than large caps stocks. Thus, more volume tends to trade at the close and to some degree at the open. Historically, many investors have taken advantage of the liquidity found at the close to trade add/delete names ahead of the reconstitution. For example, when managing Russell 2000 reconstitution and an investor wishes to remain notional or beta hedged, they can execute a CME E-mini Russell 2000 Index futures BTIC transaction in the opposite direction.

Summary

Reconstitutions, especially on large benchmark indices are major events in the equity calendar, that presents risk management challenges for some and potential alpha trade opportunities for others. The use of CME Equity Index futures can be employed in a variety of ways to help either manage these risks or aid in the implementation of alpha trade opportunities. This can be achieved using the liquidity found on CME Globex intraday, by using BTIC transactions to trade futures off the cash close, or by executing an EFP to switch between stock and futures positions.

References

  1. All such EFPs must be executed in accordance with CME Rule 538 (“Exchange for Related Position Transactions”) and the Market Regulation Advisory Notice concerning Rule 538.
  2. All BTIC transactions must be executed in accordance with CME Rule 524.B. (“Basis Trade at Index Close (“BTIC”) Transactions”), the Market Regulation Advisory Notice concerning Rule 524 and the provisions in the applicable product chapter.
    For more information on Rules 538 and 524, please visit the Market Regulation Advisory Notice page on the CME Group website available here.
  3. Pursuant to the requirements of CME Rule 524 (“Block Trades”).

About CME Group

As the world's leading and most diverse derivatives marketplace, CME Group is where the world comes to manage risk. Comprised of four exchanges - CME, CBOT, NYMEX and COMEX - we offer the widest range of global benchmark products across all major asset classes, helping businesses everywhere mitigate the myriad of risks they face in today's uncertain global economy.

Follow us for global economic and financial news.

CME Group on Twitter

CME Group on Facebook

CME Group on LinkedIn