- 2001: Volume 10, No. 5 Hedging Investment Portfolios Using E-mini Stock Index Futures

Over the last 19 years, the U.S stock market has enjoyed one of the greatest run-ups in history. As measured by the benchmark S&P 500 Index, the annualized compounded return on the market was around 15 percent. Investors small and large have become more market literate as the number of mutual funds exceeds 9,000 and the number of 401(k) accounts in the U.S. exceeds 41 million. In fact, for many, the 401(k) account represents one of their largest assets, if not the largest. Trillions of dollars also reside in taxable mutual funds and with private money managers.

But as we all know—especially during the last 12 to 18 months—stock values don't only move upward. Stocks slid nearly 20 percent in just a few months in 1998's third quarter, causing jitters among investors in the U.S. markets. In addition, investors experienced declines during the 2000 calendar year as the S&P 500 showed double digit losses and the Nasdaq-100 was also down substantially. Eight months into 2001 the market continues its downward trend from last year as the major averages continue to show losses. Many wonder how bad it could get and if there is a way to protect their portfolios from significant losses.

In fact, there are ways to protect a portfolio of stocks using a variety of futures strategies. This section will focus on one in particular-using stock index futures to hedge equity portfolios. We will also illustrate how investors can use stock index futures to gain market exposure-the so-called "anticipatory hedge." Before we outline the strategies, there are a few items to consider:

• Size of portfolio
• Construction of portfolio
• Correlation of the portfolio to CME's stock index futures
• Tax considerations

Size of Portfolio
CME's flagship S&P 500 contract had a notional value (or contract size) of around $335,000 as of January 2001. The E-mini S&P 500, which trades very closely to its larger brother, has a value about one-fifth the size, or $67,000. Hence investors with IRAs/401(k) accounts or portfolios less than $67,000 in size would not be able to use these products effectively. For example, an investor has $25,000 in an index fund that replicates the S&P 500 composite. If the investor wanted to hedge using the CME's mini S&P 500, he would be hedging a $25,000 portfolio with an instrument with a value of $67,000--he would be "overhedged" by $42,500 (you could say his hedge would be out of balance).

Construction of the Portfolio
To benefit from using the various CME stock index products, the investor's portfolio must have a significant component of U.S. equities. Many investors, especially more conservative investors, have sizeable stakes in bonds, money market funds, convertible securities, and so on. CME stock index futures are not designed to hedge fixed income instruments, but to hedge equity portfolios that correlate highly with a particular index such as the S&P 500, S&P MidCap 400, Nasdaq100® and the Russell 2000®.

Correlation of Equity Portfolios to CME Stock Index Products
Assume that you have a large enough portfolio and that it is composed mainly of U.S. equities. The next thing would be to determine how closely the portfolio tracks the underlying indexes on which CME stock index futures are based. For example, the S&P 500 comprises mostly larger capitalization stocks such as General Electric, Cisco, Microsoft and Exxon (and 496 other issues). If you owned shares in an S&P 500 index fund or even a fund/portfolio that had a lot of large capitalization stocks, the correlation of the fund should be high and the S&P 500 or mini S&P 500 futures contract might be a good vehicle to hedge against a declining market. On the other hand, if your portfolio were to include smaller capitalization stocks or even mid-size stocks, the correlation of these stocks to the S&P 500 would be lower and a futures contract based on the S&P 500 may not be suitable for your hedging purposes. A more appropriate hedge might be constructed using Russell 2000 futures or S&P MidCap 400 futures. Of course, you would first have to determine how well your portfolio tracks these indexes.

Tax Considerations
The taxation of futures is different from other investments and depends on the status and strategy of the taxpayer. Is the taxpayer a trader? Investor? Dealer? Hedger? Any gains or losses arising from these transactions usually are subject to both the mark-to-market and the 60/40 rule at the end of the tax year. Generally this type of transaction is reported on the appropriate IRS form (Form 6781-Gains/Losses from Section 1256 Contracts and Straddles) and transferred to your Schedule D filing. You should consult your tax advisor to determine which rules apply to you. While tax treatment of an overall hedging strategy may be complicated, the protection that can be offered by such a strategy merits consideration.

Protecting Your Portfolio
Figure 1 displays several mutual funds along with investment returns and other information during a period in 2000, a year of generally declining stock prices. Why did I pick these funds? When the market heads south, certain mutual fund investors that have a modicum of knowledge of hedging begin to call CME. During a couple of nasty weeks in the market, I received numerous inquires about hedging mutual fund holdings and other portfolios using the E-minis. Some of the funds listed were, in fact, held by these callers. Instead of identifying them by name (and I don't always get their name), I use the fund holdings they were interested in hedging as the identifier. These calls were received over a two-month time frame, an intriguing coincidence. But when the market breaks, fear sets in and some investors worry that the extraordinary gains they have earned over the last several years will evaporate in a bear market. While I have no idea if these investors ever acted after these conversations took place, I will briefly recount some of the discussions.

Figure 1

Using E-mini Stock Index Futures To Hedge Portfolios
Investor/Fund	Amount Invested	Price 03/24/00	Price 05/24/00	Percent Returned	R- Squared	Comments
Vanguard 500 Janus Fund T Rowe Price Blue Chip Mutual Qualified Fund S&P 500 Cash June S&P 500 Futures	$400,000 $110,000 $52,000 $900,000 n/a n/a	140.74 50.34 39.75 17.14 1527.46 1555.40	127.54 40.65 35.56 17.64 1399.05 1401.70	-9.38 -19.25 -10.54 2.90 -8.41 -9.88	100 72 95 67 n/a n/a	Could use futures Tracking error, not great fit Inadequate investment size Low correlation to futures n/a n/a
On 3/24/01, S&P 500 futures continued trading until 3:15. On this day futures ran up considerably after the cash markets were closed. Their "fair value" was approximately 1545.00. At this level, the percent decline from 3/24 to 5/24 would have more closely matched the cash decline. In fact, it would have been 9.4 percent.

Along with fund name and amount invested, we have price data for an eight-week period, including the percent decline. We have also included the performance of the underlying cash indexes and their corresponding futures contracts since those would be the instruments used to hedge the funds. The table also includes some data on R-squared values. R-squared ranges from 0 to 100 and reflects the percentage of a fund's movements that are explained by movements in its benchmark index. (Caution: R-squared is not a predictor of relative performance or profitability.) An R-squared of 100 means that all movements of a fund are completely explained by movements in the index. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100 since they invest in the index itself. A low R-squared means that very few of the fund's movements are explained by movements in its benchmark index. Put another way, funds with lower R-squared values move to the beat of a different drummer and will not mimic the moves of the S&P as well over the long run. In very general terms, high R-squared values mean a portfolio has a good correlation with its benchmark--S&P 500.

The first investor had a $400,000 balance in the Vanguard 500 Index fund. I told him he had an adequate balance and that his correlation to the S&P 500 is perfect. It should be as the fund perfectly replicates the index. That fund was down about 9.4 percent. The S&P 500 futures (and the mini S&P 500) were down about 9.88 percent. Basically the fund was a very good candidate for hedging—if he chose to do so. He had a large enough portfolio and a good correlation with the futures—so it would have been a good hedge. It doesn't get any more simple.

The second investor had $110,000 in the Janus Fund. The amount invested was not adequate for the regular S&P 500 futures but could be hedged using two mini S&P futures. However, two minis would have a value of $140,000. He would be hedging a $110,000 investment with a $140,000 "insurance policy"-he would be overhedged. Not a bad thing in a bear market but a bit risky should stocks move upward. I also conveyed that the fund was a bit concentrated and had a large tilt toward technology. This explains why it declined twice as much as the index. Hence, if this investor hedged using the E-mini S&P 500 he would have made some profits on the hedge, but not enough to cover the severe decline the portfolio experienced. In summary, I had to confess that the tracking error and concentrated nature of the portfolio could be a problem.

The next caller had $52,000 in the T-Rowe Price Blue Chip fund. Again, this fund correlated well with the overall market, had a high R-squared. S&P futures would have been useful as a hedge in this case too. But, unfortunately, this investor had too small a portfolio. Even one mini S&P 500 contract is too large for the amount of assets to be hedged. The person then asked if these new "Spider stocks" might be useful. I smiled and replied yes and sent her to the AMEX (trying to be a good samaritan!).

The last caller had almost a million dollars in the Mutual Qualified fund. Since I had some of my own money in this fund I knew it well. Although the investor did have a large enough asset base, there were some items that made this fund a less attractive candidate for hedging with S&P futures. The Mutual Qualified fund is loaded with stocks that many other fund managers would never touch. Michael Price, who ran it for most of its operating history (before he sold his fund company to Franklin Templeton), had an interesting collection of investments. The portfolio had a huge value tilt, including many bankruptcy candidates, companies reorganizing out of bankruptcy, junk debt and a whole collection of investments that much of the Street avoided. Too bad for them, as this and other Mutual Series portfolios had amassed a superb track record (except for during the dot.com mania, where many value investors were left in the dust by technology). Indeed, as 2000 unfolded and much of the technology space become toxic waste, Mutual Qualified did what it usually does in adverse markets--it went up. If this investor had hedged, he would have made money on the hedge as the market slid and would have profited on the investment being hedged since the fund was up 2.9 percent during this time frame. It is nearly impossible to profit on both sides of a hedge! All things considered, the low correlation means that S&P 500 futures would not provide a good reliable hedge in this case. (Note: During the 73-74 bear market, when the S&P was down nearly 50 percent, Price's flagship fund, now run by the great team he left behind, was down less than two percent--an amazing but little known accomplishment in the investing world.) To reiterate, the investor must closely consider the size of the portfolio to be hedged, the construction and the correlation to the futures contract. If an investor had investments primarily in small cap issues, then the Russell 2000 futures might be more appropriate than the S&P 500 in this case.

We will now provide details on how such hedges might be constructed. Remember, hedging is insuring against an adverse price move. An adverse price move to a fund holder is a down market. Thus hedges of this sort are also called short hedges, since the investor would have to sell short a futures contract to protect against an adverse price move. If the market did slide, the profits on the short hedge would hopefully offset the losses on the portfolio of stocks.

Conclusion
Over the last 15 years, CME's stock index futures product line has seen tremendous growth. Much of the success in these products is because of their advantages to large institutions such as banks, pension funds and mutual funds. Used properly, these products provide superb risk management and trading opportunities. Their usefulness, however, is not limited to billion-dollar institutions. Suitable individual investors with adequate risk capital and the appropriate type of portfolios can successfully employ these vehicles too.

Strategy I:
Hedging a Portfolio with
Stock Index Futures-The Short Hedge

Suppose you own a mutual fund or portfolio of stocks that is highly correlated with the S&P 500 composite index (R-squared = 98). The current value of the portfolio is $140,000.

Time frame: Early November
Outlook: Short-term bearish-looking for a decline of at least 10%-15%.
Strategy: Sell 2 E-mini S&P 500 futures contracts to hedge portfolio.*

Current S&P 500 index (cash): 1,400.00 pts.
Current E-mini S&P 500 futures (Dec futures): 1,415.00 pts.**

* Each E-mini S&P futures is worth $70,750 (1415 x $50 per pt. = $70,750); thus, two contracts would be required to hedge a $140,000 portfolio.
** Futures contracts usually trade at a premium to the cash index due to cost-of-carry factors. As expiration of the futures contract nears, this premium will converge toward zero.

Outcome:
Four weeks later the S&P 500 declines 15% to 1190.00.
Investor's portfolio declines 15.5%.
December future declines 15.5% to 1195.00.

Profit/Loss picture: Value of portfolio early Nov: Value of portfolio early Dec: Profit/Loss on portfolio Value of E-mini S&P 500 early Nov: Value of E-mini S&P 500 early Dec: Gain on short hedge x 2 ($140K portfolio required two futures) Hedged Portfolio: Loss on portfolio Gain from futures hedge Overall profit/loss Unhedge Portfolio: Loss on portfolio Gain from futures hedge Overall profit/loss

$140,000 $118,300 - $ 21,700 $70,750 (1415 x 50 = $70,750) $59,750 (1195 x 50 = $59,750) + $11,000 + $22,000 - $21,700 + $22,000 + $300 - $21,700 n/a - $21,700

In this hypothetical example, the hedge using E-mini stock index futures fully protected the portfolio against a decline. The decline in your portfolio was offset by gains in the two E-mini S&P futures contracts. You preserved the value of your portfolio despite a significant decline in the market of 15 percent! On the other hand, if the market had advanced, the portfolio's gains would have been offset by losses on the two E-mini S&P 500 futures contracts. If this were to occur the investor would have had to consider removing his hedge by buying back the short futures contracts so he/she could participate in any further upside action.

Strategy II:
Using E-mini Nasdaq-100 Futures to
Gain Market Exposure-The Long Hedge

You are expecting a large cash infusion due to the sale of a business. Since you believe that technology stocks are at attractive levels, the cash proceeds (about $100,000) will be invested primarily in high-tech stocks at close of deal in four to five months.

Problem:
You are very bullish near-term, especially on technology stocks. You lack sufficient cash to construct portfolio immediately.

Strategy:
Execute Long Hedge by buying 3 E-mini Nasdaq 100 futures contracts (3 contracts were worth approximately $100,000 in August 2001).

Advantages:

• Easy to execute
• Less costly and more efficient than buying a basket of stocks
• Initial cash outlay or performance bond would be much less than $100,000 (in fact it would be less than 17% of that amount-about $5,240 per contract x 3 or $15,720)

If the market rose before you received the $100,000 in proceeds, the futures would also tend to rise, allowing you to participate in the advance. Four to five months later, you could purchase the stocks. The higher price that you would pay would be offset by the profits in the futures contracts. If the prices of stocks (and therefore the Nasdaq-100) declined, your futures contracts would lose money. However, the cost to purchase your portfolio would also be reduced. This "anticipatory long hedge," as it is sometimes called, allows you to enter the market immediately at a fraction of the cost.

David Lerman is the senior director of equity index products marketing at the Chicago Mercantile Exchange and the author of Exchange Traded Funds and E-mini Stock Index Futures. He has traveled around the globe on behalf of the CME, giving seminars and workshops to retail and institutional audiences, including pension funds, corporations, banks and brokers on risk management/trading using equity index futures and options.