Managing an Equity Index Reconstitution

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.

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.

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.

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.

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.