Achieving Social Mandates with CME Equity Index Futures

As of November 20, 2014, there were 43 constituents in the S&P 500 Index that were classified as within the GICS level 1 Energy sector. In aggregate, it accounted for 8.97% of the portfolio value of the S&P 500 index. Figure 1 shows the breakdown of the S&P 500 index by GICS level 1 sectors¹.

Amongst the Energy sector constituents of the index, the weight distribution is highly concentrated in the largest constituents. As a result, if the constituents were to be segregated into its own portfolio, it would be very top heavy to the extent that it would fail to be regarded as a broad-based index. The S&P Energy Select Sector Index applied a modified weight to redistribute the weight away from the largest constituent, thereby making the index more broad-based. Figure 2 shows the relative weights.

Denoting the weight of the Energy sector in the S&P 500 Index as W, the correct proportion of notional value, or the hedge ratio, should be:

Note that the ratio remains 1 to W, while the total investment remains 1.

As previously mentioned, the S&P Energy Select Sector Index reweights the components to limit the concentration of weights in the largest market capitalization stocks in the portfolio². It necessarily leads to shifting of weights to the stocks with lower market capitalization. Since lower market capitalization stocks typically exhibit higher price volatility, one could expect the S&P Energy Select Sector Index to exhibit higher volatility than the S&P Energy Sector Index, which inherits the portfolio makeup of the S&P 500 GICS level 1 Energy Sector constituents. The comparison is shown in Figure 4. It is true to varying degree. Notwithstanding the differences in volatility, however, the realized correlation between the two indexes are consistently high. Figure 5 shows the 60- and 120-day correlation between them. They generally exceed 0.99 and often exceed 0.995.

where the Adjustment Factor = correlation between the two Energy Sector Index x volatility(GICS Level 1 Index) / volatility(Energy Select Sector Index). This adjustment factor³ is typically less than 1 since the Select Sector Index is typically more volatile than the GICS Level 1 Index, and correlation between the two cannot exceed 1.

The trade is illustrated based on the assumption that one would like to deploy $100 million on November 21, 2014. The hedge ratios at the close are 1.0981 and -0.0952 for S&P 500 and S&P 500 Energy Select Sector indexes, respectively. Thus, the notional amount of the trade for S&P 500 and the Energy Select Sector are $109.81 million and -$9.52 million, respectively. The number of CME E-mini index futures contracts can be determined as follows:

where (d) = (a) / ( (b) x (c) ), rounded to the nearest integer.

Therefore, a combination of long 1,065 E-mini S&P 500 index futures and short 108 E-mini S&P Energy Select Sector index futures would replicate the exposure using listed derivatives at CME Group.

As with any futures positions, collaterals are required at the clearing house to secure the position. In the case of index futures, long/short spread positions between correlated index futures would benefit from an offset. As of November 21, 2014, the outright maintenance margin for E-mini S&P 500 index futures and the E-mini S&P Energy Select Sector index futures are $4,600 and $4,000, respectively. A 1:1 long/short spread between the two contracts would enjoy a margin offset of 80%.⁴

The outright margin is simply the number of futures contracts times the per contract margin requirement. The margin for a long/short spread position is the total margin for each side of the spread position, reduced by the offset percentage. In the case of the 1:1 spread in question, the maintenance spread margin is ($4,600 + $ 4,000) x (1 – 80%) = $1,720 per 1:1 spread. The initial margin is 10% higher than the maintenance margin as of this writing.

Thus, as of November 21, 2014, and initial margin of just over $5 million is sufficient to secure the futures position that mimics the S&P 500 ex-Energy Index with a notional value of $100 million.

Figure 7 shows the efficacy of the futures replication strategy. The graph shows that the strategy tracks the S&P ex-Energy Total Returns Index very well.

The futures replication strategy depicted in this short article provides an easy way to achieve the returns on the S&P ex-Energy Sector Index, which fulfills certain social mandates that require asset managers to divest fossil fuel related investment. Given the modest collateral requirements of the strategy, it can co-exist with other strategies, e.g. portable alpha.

The foregoing strategy proves to be an effective way of replicating one of the most popular social investment mandates: the divestiture of companies involved in the Energy Sector associated with carbon-based energy production. This analysis demonstrates how a combination of index futures can synthesize investment strategies that restrict exposure to the Energy Sector.

One of the by-products of the strategy is that capital can be freed to deploy in other socially responsible investments.

¹The Global Industry Classification Standard (GICS), co-developed by MSCI and Standard & Poor’s, is an industry taxonomy for use by the global financial community. There are 10 Level 1 Sectors as well as lower level Industry Groups, Industries and Sub-industries. The Energy Sector is one of 10 Level 1 Sectors within the GICS taxonomy. “GICS” is a registered trademark of McGraw-Hill and MSCI Inc.

²For a detailed description of the capping methodology, please consult the S&P U.S. Indices Methodology, available from S&P Dow Jones Indices.

³This adjustment factor is equivalent to the slope parameter of regression the returns on the S&P Energy Select Sector Index on the returns on the S&P GICS Level 1 Energy Sector Index.

⁴Margin levels and the offsets do vary over time as market condition dictates. Please consult information published by CME Clearing for up to date information.

⁵CME Group’s E-mini S&P Select Sector Index Futures were launched in March 2011. Market maker program for the product started in May 2011. This simulation starts after the first roll in June 2011.

⁶Cash balances are assumed to be invested in interest bearing assets at 1-month ICE LIBOR. Commissions, Exchange Fees and other out-of-pocket costs are not included in this calculation.