- 2002: Volume 11, No. 3 The Derivatives Desk: As the World Turns

In our last episode, we left equity gastronomes wrestling with the financial indigestion wrought by consuming global sector exposure. Some sector funds, it seems, issue loud hiccups and burps as foreign stock markets gyrate. Why? Because Morningstar data shows the average sector fund holds about 12 percent of its assets in foreign equity.

Delight or nausea can be induced by finding foreign stocks on your plate. Recently, you'd be likely to slaver over your entrée if you held an energy fund. Queasiness, on the other hand, would've been your frequent dinner companion if you owned a telecom portfolio. Funds covering these sectors tend to be especially rich in foreign stock holdings with 25 to 30 percent of their assets typically invested offshore. And, as we saw in our last outing, foreign exposure can magnify the returns (both positive and negative) obtained in a sector portfolio.

Investors impacted by too much or too little foreign stock exposure are left with the question, "What to do?" Invesco sector fund holders right now might be especially fretful. One-year returns in the Invesco Telecommunications Fund (ISWCX) have been considerably worse than the fund's peer group average. The Invesco Energy Fund (FSTEX) also lags behind sector portfolios of comparable longevity. The most recent fund reports indicate ISWCX's exposure to offshore stocks amounted to 16 percent of total assets while FSTEX held a 12 percent foreign equity stake.

Year-to-date, FSTEX's 7.54 percent gain represents bottom-rung performance for the fund's peer group. Even the tradeable manifestation of the S&P Global Energy Index, the iShares IXC portfolio, outdid FSTEX by appreciating 8.74 percent over the same period. More than a few FSTEX holders must be pondering whether to hold on for better times, or to ditch the fund for a better performer. Selling out of a fund, for some investors, can produce nasty tax consequences. Another course of action can at least delay the hand-over of lucre to the tax man—overlaying the FSTEX position with a more efficient energy exposure.

More Efficient, You Ask?
Look at it this way—if foreign energy issues are identified as the sector's outperformers, investors can increase their exposure to foreign stocks by adding a dash of index fund shares to their holdings. Why index funds? Well, for one thing, only index funds are transparent enough to allow real-time surveys of their foreign stock holdings. Conventional funds only open their portfolios for inspection twice a year, and well in arrears at that. Index funds are "pure" exposures as well—designed to mirror the market slices represented by their underlying benchmarks without much human tinkering. Index funds are cheaper, too. The iShares IXC portfolio's 65 basis point (.65 percent) annual expense ratio is markedly less expensive than the FSTEX peer group's average of 149 basis points.

So, How Would This Work?
Let's suppose at year-end 2001, an investor held $10,000 in FSTEX but wanted enhanced foreign stock exposure. If the foreign component in the iShares S&P Global Energy Index Fund is 51 percent, an additional lashing of 12 percent (FSTEX's then-current foreign element) could have been obtained by purchasing about 50 IXC shares when offered at $49.54: (12% ÷ 51%) x $10,000 = $2,353 _ 50 shares.

The results of overweighting foreign exposure can be seen in Figure 1.

Figure 1:

Volatility is more mellow in the IXC-enhanced FSTEX portfolio and a return pick-up of 24 basis points is also obtained:

	FSTEX	IXC	Enhanced
Return Volatility	7.54% 20.84%	8.74% 14.28%	7.78% 18.56%

While the risk-adjusted return of the enhanced portfolio betters that of FSTEX alone, all is not beer and skittles for our investor. First of all, he needs liquidity. The enhancement strategy requires the application of fresh capital (margin may used for larger-sized overlays, but that's a story best left for later). Here, the vital consideration is whether the strategy cost can be recouped through outsized performance. Our investor must ask himself, "Could $2,400 be better deployed elsewhere?"

Embedded in the strategy's cost, too, are commissions. Round-turn transaction costs offset the ameliorative effect of the exchange-traded funds' lower expense ratio, especially if the overlay is held short-term. FSTEX's expense ratio, at 141 basis points, is fairly average for its peer group. Overlaying IXC brings the annual management expense down to 126 basis points. Spreading a $30 round-turn commission over a year-long holding period cranks up expenses to 150 basis points, nine 'bips' higher than where our plucky investor started. Keep in mind that the impact of the overlaid position's transaction costs, expressed as an expense ratio, diminishes over time.

Bottom-line?
For the enhancement strategy to work, the return pick-up has got to overcome the net costs incurred. Year-to-date, this strategy's enhanced our investor's return by 15 basis points (24 bps return enhancement - 9 bps one-year net cost increase = 15 bps). Only our investor can decide whether the anticipated enhancement of returns is actually worth all the trouble.

And then there are taxes. Lifting the overlay at a profit will engender capital gains tax liability. Our investor's tax savviness, or that of his advisor, will be tested by weighing the implications of a simple FSTEX replacement versus an overlay strategy.

Index funds can also be used to reduce foreign exposure, or to hedge a mutual fund's value until a more favorable redemption environment arises.

To hedge foreign stock exposure, an appropriate number of exchange-traded index fund shares are sold short. The foreign equity stake in $10,000 worth of the Invesco Telecommunications Fund (ISWCX), for example, could have been hedged at the beginning of 2002 with about 60 shares of the iShares Global Telecommunications Index Fund (IXP):

(16% ÷ 54%) x $10,000 = $2,963 _ 60 shares where:

• ISWCX foreign equity exposure is 16 percent
• IXP foreign equity exposure is 54 percent
• IXP offered at $51.66

Unhedged, year-to-date IWSCX losses amounted to more than 24 percent. The hedged position, while still ending up underwater in March, tames some of IWSCX's losses and volatility:

	IWSCX	IXP	Hedged
Return Volatility	24.37% 32.05%	-12.70% 21.76%	-20.43% 27.25%

Figure 2 illustrates the positions' relative performance. Note that the opportunity for profit isn't swamped by the hedge. In fact, the hedged portfolio for a time actually outperformed both underlying component funds.

Figure 2:

So, What's Wrong With This Picture?
Well, for one thing the hedge requires the use of a margin account. And brokers may not have an interest in facilitating 60-share short positions. That notwithstanding, short selling, even done as a hedge, may not be appropriate for some investors. Remember, the short leg carries an open-ended loss potential. Liquidity will have to be maintained to ultimately buy-in the short position and to meet any maintenance calls but at least securities, rather than cash, can be used to meet the position's initial margin requirement.

Another thing to keep in mind is this: no matter how long you hold the index fund leg, losses and gains are always treated as being short-term.

All this sounds pretty complicated, doesn't it? Want a simpler approach to hedging and return enhancement? Then stick around for our next installment. In the meantime, pass the TUMS...

Brad Zigler's articles on derivatives and indexing have appeared in numerous financial publications. He can be contacted via e-mail at brad_zigler@hotmail.com.