E-mini S&P Select Sector Index Futures Strategy Paper


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Flexible E-mini S&P Select Sector index futures contracts have multiple applications. They can be used individually to adjust sector weights, as overlays with E-mini S&P 500 futures to adjust exposure for an existing positions, and more. This paper discusses how portfolio manager may use them as a means to better replicate or hedge investment-style exposure, and includes examples

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E-mini S&P Select Sector Index Futures Strategy Paper

  1. 1. EQUITYE-mini S&PSelect SectorIndex FuturesStrategies for Hedging and ReplicatingSabrina SuFinancial AnalystEquity Research & Product DevelopmentJohn NyhoffDirectorEquity Research & Product DevelopmentRichard CoDirectorEquity Index Prices & ServicesHow the world advances
  2. 2. E-mini S&P Select Sector Index Futures: Strategies for Hedging and ReplicatingE-mini S&P Select Sector Index FuturesNine new tools for more effective portfolio management.For investors seeking a more refined and efficient proxy for their equity Multiple applications. E-mini S&Pmarket exposure, CME Group now offers nine flexible E-mini S&P SelectSector index futures contracts with multiple applications. Designed Select Sector futures can be usedto closely match the performance of each sector within the S&P 500, individually as sector weightingE-mini S&P Select Sector index futures can be used individually for tools, or as overlays to adjustadjusting sector weights, or as overlays with E-mini S&P 500 futuresto adjust exposure for an existing position. What’s more, they deliver existing positions.several potential margin efficiencies with other equity index futures— a benefit that may not be available by simply holding an underlying In addition to their effectiveness in managing sector weight, E-mini S&Pbasket of stocks or ETFs. Select Sector futures have another valuable potential application — as a means to better replicate or hedge investment-style exposure. WhenBecause each constituent of the S&P 500 index is categorized into portfolios were created to replicate investment-style performancea specific sector, portfolio managers and investors with different (using E-mini S&P Select Sector futures overlaid with S&P 500 futures)risk tolerance levels can use E-mini S&P Select Sector futures to and then compared to respective S&P style index portfolios, thecapture the desired level of sector risk to manage their equity portfolio resulting performance tracking errors were consistently low and stable,objectives, as illustrated below. offering much better results than attempts to replicate performance using S&P 500 futures alone.Capturing Sector Risk for a Portfolio Stock Portfolio Portfolio Sector E-mini S&P Select Components Sector Futures Portfolio Sector A A Sector B B Sector C C Sector D D Sector E ENote:• Squares represent stocks in a stock portfolio• Different colors represent different sectors2
  3. 3. cmegroup.com/sectorsDefining Our Objective This paper addresses two methods for replicating the performanceIn this paper, we will attempt to replicate the performance of the of the Style indexes: (1) The Sectors-Only strategy, uses a set ofS&P Style Indexes — in this case, the S&P 500 Growth Index and the E-mini S&P Select Sector futures to represent a significantthe S&P 500 Value Index — with hedge/overlay strategies using the portion of the Style index constituents; and (2) The Sector OverlayE-mini S&P Select Sector and S&P 500 futures. Close inspection strategy, overlays highly liquid E-mini S&P 500 futures with a set ofof the S&P 500 Index and the Style sub-indexes shows that each E-mini S&P Select Sector futures to replicate Style indexStyle sub-index comprises stocks from sectors that are more aligned performance.to either “growth” or “value” orientations, only with different weights To implement either strategy, we first must break down the Styletowards each sector to present its particular market directional index constituents into their respective market sectors and calculateexposure. Intuitively, different combinations of E-mini S&P Select the weight of each sector in the Style index. This is necessary due toSector futures together with S&P 500 futures may more closely the generally high rate of return correlations among the E-minireplicate the performance of Style indexes than attempts to replicate S&P Select Sector futures (as shown in Exhibit 1). A reasonablethe performance of the Style indexes using S&P 500 futures alone. number of sectors is sufficient to create an effective replicationDissecting the Indexes strategy. The marginal improvement on a style-index-replicatingThe S&P 500 Growth and Value Indices segment all stocks from the portfolio’s performance that comes from adding more sectorparent S&P 500 Index into growth and value components, and weight exposure will be limited, and the decision of whether to addthem by market capitalization. The S&P 500 Style indexes divide the more will depend on the investor’s personal risk tolerance.complete market capitalization of the S&P 500 Index approximatelyequally into growth and value indexes. Thus, they cover all stocks inthe S&P 500 Index. Stocks that do not fall into Style baskets havetheir market caps distributed between growth and value indexes.Exhibit 1: Correlations Among the Nine Market Sectors (May 2009 – May 2011) Materials Energy Financials Industrials Technology Consumer Utilities Health Consumer Staples Care Discretionary Materials 1.00 Energy 0.88 1.00 Financials 0.79 0.75 1.00 Industrials 0.88 0.84 0.82 1.00 Technology 0.82 0.77 0.76 0.87 1.00 Consumer 0.71 0.68 0.65 0.77 0.74 1.00 Staples Utilities 0.68 0.72 0.62 0.74 0.71 0.74 1.00 Health Care 0.68 0.67 0.63 0.73 0.72 0.79 0.70 1.00 Consumer 0.82 0.77 0.79 0.91 0.87 0.76 0.70 0.71 1.00 Discretionary 3
  4. 4. E-mini S&P Select Sector Index Futures: Strategies for Hedging and ReplicatingAfter taking a close look at the weighting scheme shown in Exhibit 2 strategy might include Energy, Financials, Technology, Utilities andbelow for each sector in the S&P 500 Growth and Value Indexes, we Consumer Discretionary sectors (in this case, we considered theadjusted our replicating strategies to include four or five applicable sector’s weighting differential for the Growth Style Index vs. theE-mini S&P Select Sector futures, as a portfolio manager might S&P 500 Index). attempt to do in a real-life application. We identified a combination For portfolios benchmarked to the S&P 500 Value Index, we choseof sector components significant enough to represent each index. the first combination of sector futures for the Sectors-Only strategyWe also compared the composition of each Style index to that of to include Energy, Financials, Industrials, Consumer Staples andthe S&P 500 Index in order to identify sectors with weights that Health Care sectors. The second combination of sector futures,vary significantly from the S&P 500 Index composition scheme. for the Sector Overlay strategy, is the same as that for the GrowthBy incorporating the appropriate E-mini S&P Select Sector futures Index but with reverse weights to adjust the S&P 500 portfolioas an overlay to E-mini S&P 500 futures, we could replicate the toward a different market risk direction.performance of the Style indexes.Based on the weights of each sector as of June 3, 2011 (illustratedin Exhibit 2), for portfolios benchmarked to the S&P 500 Growth Replicating the performance of theIndex, the combination of E-mini S&P Select Sector futures for the S&P Style Indexes. The first step is toSectors-Only strategy might only include the E-mini Industrials,Technology, Consumer Staples, Health Care and Consumer break down the Style index constituentsDiscretionary Select sector contracts (all of which had higher into their respective market sectors andweightings with the Growth Style Index, as Exhibit 2 shows).Alternatively, the combination of E-mini S&P Select Sector calculate the weight of each sector in thefutures overlaid on the S&P 500 futures for the Sector Overlay Style index.Exhibit 2: Sector Composition of Styled Indexes S&P 500 S&P Growth S&P Value35.00%30.00%25.00%20.00%15.00%10.00% 5.00% 0.00% s y ls ls y s es a re y ple ial nc e rg log cia ria liti hC ter pa Sta no u st En an Uti c re Ma alt h Fin Ind Tec er Dis He um er ns um Co ns Co4
  5. 5. cmegroup.com/sectorsConstructing Replication Strategies sectors with significant differential weights — one should want toFor comparison purposes, we calculated the tracking performance adjust the S&P 500 portfolio to be more aligned to a Growth Stylebased on the following three strategies: portfolio. We also repeated this process in an attempt to replicate Value Style portfolio performance. 1. Sector futures Only: Weighted by statistical hedge ratios (Sectors-Only strategy) Comparing the Two Sector Overlay/Combo Strategies We would intuitively expect that the statistical hedge ratios (derivedA single set of hedge ratios for the identified sector futures was from regression on historical performance data of Sector indexesbased on a regression analysis using the most recent two years of and the Style benchmark index) should be consistent with the weightindex returns data (May 2009 – May 2011). differential of one sector in the Style index and the S&P 500 Index.2. Combination of Sector and S&P 500 futures: Weighted Exhibit 3, however, shows that the two combo overlay strategies, with by statistical hedge ratios (Sector Overlay – Hedge different weighting methods for replicating portfolio benchmarked Ratios strategy) to S&P 500 Growth Index, would have different (and sometimes conflicting) allocations in the Select Sector futures. This is also trueTo construct replication strategies for the Style indexes, we have, for the two Sector Overlay/Combo strategies for the S&P 500 Valueat our disposal, the highly liquid, broad-based equity index futures portfolio. The reason is that the statistical regression method wouldavailable at CME Group exchanges. For the S&P Style indexes, using detect the correlation among the market sectors during the periodCME E-mini S&P 500 futures would be the default strategy. To hedge of our two-year data sample. The regression method also tends tothe Style indexes more effectively, we could reduce the weights of optimize the statistical effect. It does so by eliminating sectors thatthe growth sectors and increase the weights of the value sectors, would only add marginal improvement in performance fit but mayor vice versa. We have already picked the sectors with significant be considered statistically insignificant. Indeed, in terms of trackingdifferential weights from the S&P 500 Index for each index. The errors, the Sector Overlay combo strategy with sector weighthedge ratios were then derived statistically from regression on the differentials performs better than the Sector Overlay combo – Hedgemost recent two years of index returns data, including that of the Ratio strategy. We explore this further in the following section.S&P 500 Index. By adjusting for the significantly different exposureto certain sectors in the Style portfolio, this strategy effectivelycaptures market direction risk. Note that, based on our two-year Exhibit 3: Hedge Ratios (HRs) of Three Hedging Strategiesdata sample, we found that the Consumer Discretionary sector for S&P Growth Index Portfoliois not statistically significant, and is excluded in the replication Sectors Onlystrategy for both Style indexes. Sectors & SPX (Statistic HRs)3. Combination of Sector and S&P 500 futures: Weighted Sectors & SPX (Weight differential HRs) by sector weight differential (Sector Overlay – Weighted 1.2 Differential Strategy) 1A more intuitive approach is to adjust the Select Sector market 0.8exposure of the S&P 500 overlay strategy to replicate Style 0.6portfolio performance, using the differential between the weights 0.4of one Sector in the Style Index and the S&P 500 Index (the Sector 0.2Overlay – Weighted Differential strategy). Referring back to sector 0composition percentages illustrated in Exhibit 2, for each dollar –0.2exposure to S&P 500, 0.128 dollars is exposed to the Energy sector, c. s y ls ls y s es a re 00 orwhile for each dollar exposure to S&P 500 Growth, only 0.0752 ple ial e rg log Dis cia ria Lib liti P5 hC ter Sta no u st En andollars should be invested in the Energy sector. Thus, to track the Uti n s. S& Ma alt h Fin Ind Tec n s. CoGrowth portfolio’s exposure to the Energy sector, one would want to He Cobe short 0.0528 dollar’s worth of energy sector futures on top of theone dollar invested in S&P 500 futures. The same applies to other 5
  6. 6. E-mini S&P Select Sector Index Futures: Strategies for Hedging and ReplicatingMonthly Tracking Errors Taking a closer look at the monthly tracking error data (Exhibit 6Exhibits 4 and 5 show the monthly performances of the three sector provides the summary statistics), we can conclude that:futures strategies together with the S&P 500 stand-alone strategy,relative to those of the Style indexes over the sample period May »» For both Style indexes, the Sector Overlay/Combo strategies using E-mini Select Sector futures and E-mini S&P 500 futures2009 through May 2011. Note that the strategy with sector indexes working together track the benchmark better than either of theweighted by weight differential on top of the S&P 500 Index provides stand-alone strategies.stronger performance replication for the S&P 500 Growth Index andthe S&P 500 Value Indexes, respectively. »» Within the Sector Overlay/Combo strategies, the strategy with sectors weighted by weight differential hedge ratios — the more intuitive strategy — provides more favorable average trackingExhibit 4: Tracking Error Performance of HedgingStrategies vs. the S&P 500 Growth Index error, yet with a bit higher variability of the tracking errors. Since the reduction in average monthly tracking error is large relative SGX Index Sectors + SPX (Statistic HRs) to the difference in the standard deviation of the tracking error, Sectors Only Sectors + SPX (Weight differential HRs) we believe the intuitive hedge ratios may be sufficiently effective for replication purposes with easier maintenance. SPX Only 1.55 1.55 Exhibit 6: Monthly Tracking Error Statistics in Basis Points 1.45 1.40 1.35 S&P 500 Sectors Sectors + Sectors + 1.30 Only Only S&P 500 S&P 500 1.25 (Statistic (Weight 1.20 HRs) differential HRs) 1.15 1.10 S&P Growth 1.05 1.00 Avg. Monthly –6.24 18.01 3.68 –0.44 0.95 Tracking Error May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Std. Deviation 83.35 74.14 50.79 57.87 S&P Value Avg. Monthly 6.32 –3.12 –4.36 0.19Exhibit 5: Tracking Error of Hedging Strategies vs. the Tracking ErrorS&P 500 Value Index Std. Deviation 87.95 69.72 53.34 61.32 SVX Index Sectors + SPX (Statistic HRs) SPX Only Sectors + SPX (Weight differential HRs) Sectors Only 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-116
  7. 7. cmegroup.com/sectorsAppendix 1: Hedge Ratios for the Three Strategies (May 2009 – May 2011) S&P 500 Growth S&P 500 Value Sectors Only Sectors + SPX Sectors + SPX Sectors Only Sectors + SPX Sectors + SPX (Statistic HRs) (Weight (Statistic HRs) (Weight differential HRs) differential HRs) Materials Energy 0.03 –0.05 0.11 –0.03 0.06 Financials –0.11 –0.10 0.29 0.12 0.10 Industrials 0.24 0.23 Technology 0.41 0.16 0.12 –0.17 –0.12 Consumer Staples 0.12 0.19 Utilities –0.04 –0.03 0.04 0.03 Health Care 0.16 0.16 Consumer 0.09 0.03 –0.04 Discretionary S&P 500 0.96 1.00 1.03 1.00 Libor –0.03 0.00 0.03 0.02 0.00 –0.03For more information, visit cmegroup.com/sectors or contact:Sabrina Su Richard Co John NyhoffFinancial Analyst Director DirectorEquity Research & Product Development Equity Index Prices & Services Equity Research & Product Development312 648 3727 312 930 3227 312 930 2310sabrina.su@cmegroup.com richard.co@cmegroup.com john.nyhoff@cmegroup.comFutures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than theamount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any onetrade because they cannot expect to profit on every trade. All references to options refer to options on futures.CME Group is a trademark of CME Group Inc. The Globe logo, CME, Chicago Mercantile Exchange, E-mini and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and Chicago Board of Trade are trademarksof the Board of Trade of the City of Chicago. All other trademarks are the property of their respective owners.All of the futures contracts mentioned in this paper are listed with and subject to the rules and regulations of CME. The information within this brochure has been compiled by CME Group for general purposes only. CMEGroup assumes no responsibility for any errors or omissions. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice orthe results of actual market experience. “Standard & Poor’s,” “S&P®” “S&P 500®” “S&P SmallCap 600™“and “S&P MidCap 400™“are trademarks of The McGraw-Hill Companies, Inc. These products are not sponsored, , ,sold or endorsed by S&P, a division of The McGraw-Hill Companies, Inc., and S&P makes no representation regarding the advisability of investing in them.Copyright © 2011 CME Group Inc. 7
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