- 2002: Volume 11, No. 3 The Derivatives Desk: I've Got Issues. You Got Issues?

Let's face it. Some of us just aren't cut out to trade futures or options.

First of all, finding a broker competent to recommend and execute trades ain't easy. Securities brokers outnumber futures representatives six-to-one nowadays. More than a few would-be futures traders, too, have been forced to forge new brokerage relationships because their stockbrokers are not registered to execute futures transactions. Then there's the paperwork. Futures, at present anyway, can't be traded in securities accounts; a whole new account, subject to whole new set of rules, must be opened. And let's not forget margin. Every futures trade—short or long—is nominally a margin transaction. Securities positions, in contrast, can be executed on a fully-paid basis with nary a whiff of margin.

So, what to do when the itch for say, an oil trade, needs scratching and no futures account is available or desired? The folks at California-based Gazebo, Inc. (www.gazebo.com) think they have a balm for that.

Gazebo's cooked up a batch of "Issue-Based Investing" portfolios—pairs of bullish and bearish stock baskets bracketing key commodities, interest rates, indexes, and individual stocks. The key here is the phrase "stock baskets." Formerly, oil bears had no alternative but to sell oil futures. But now, an optimized portfolio of 10 stocks, derived from Gazebo's quantitative research model, can serve as a proxy for a short oil futures position—without margin, without expiration, and without a futures account.

How does it work? Let's start with the model. A quarter of a century ago, the investment management firm which became known as Barra developed a multi-factor analytic model that literally tore apart the risk components of institutional portfolios. Gazebo adapted the multi-factor methodology for retail stock baskets that capture the movements of targeted signals—oil prices, long-term interest rates, the Nasdaq Composite Index, for example—while filtering out background market noise.

As Barra executive Jane Hiscock states, other than the Gazebo portfolios, "multiple factor models are not available to the individual retail investor."

Multi-factor analysis starts with the assumption that stock price movements are based upon three elements: systemic market forces like interest rates, company-specific factors like product launches, and random trading noise. Each stock's unique "fingerprint" is an amalgam of these factors.

Gazebo sorts through Russell 3000 Index stocks on the basis of these fingerprints, gauging each stock against the targeted metric to find stocks most-highly correlated to the metric and least correlated with systematic factors.

Figure 1

Gazebo Bullish Oil Portfolio
Company	Sector	Ticker	Weight
Ocean Energy Rowan Cos Key Energy Services Maverick Tube Patterson-Uti Energy Chesapeake Energy Ensco Int'l Noble Drilling Veritas DGC Noble Affiliates	Oil: Crude Producers Machinery* Machinery* Metal Fabricating Machinery* Oil: Crude Producers Offshore Drilling Machinery* Energy Miscellaneous Oil: Crude Producers	OEI RDC KEG MVK PTEN CHK ESV NE VTS NBL	14.99% 14.18% 11.25% 9.86% 8.69% 8.25% 8.24% 8.24% 8.24% 8.06%
* Oil Well Equip and Services
Gazebo Bullish Oil Portfolio
Forest Labs First Midwest Banc Puget Energy McDonalds FirstEnergy Southern Co Rehabcare Group Proctor & Gamble Co MGIC Investment Computer Sciences	Drugs and Pharmaceuticals Banks: Outside NYC Utilities: Electrical Restaurants Utilities: Electrical Utilities: Electrical Medical Services Soaps & Household Chem. Financial Miscellaneous Comp. Svcs Software and Sys	FRX FMBI PSD MCD FE SO RHB PG MTG CSC	14.99% 13.20% 11.63% 10.94% 8.24% 8.24% 8.24% 8.24% 8.24% 8.04%
Source: Gazebo, Inc.

And how effective are these portfolios?

Let's look at oil prices (see Figure 2). Over the five-year period ending in 2001, Brent Crude oil spot prices fell 13 percent. Gazebo's bearish oil portfolio backtested to a 133 percent gain, before costs, over that same period. That 10:1 leverage pretty much parallels the current 10 to 11 percent margin required of Brent Crude Oil futures on NYMEX, without any roll costs, either. Most importantly, though, that gain could have been attained with about half of the volatility of oil prices.

Figure 2

Not unexpectedly, the Gazebo bullish oil portfolio lost ground over the five-year period ending in 2001, but not as much as the underlying metric. The Gazebo "bullish oil" portfolio lost only four percent while actually exceeding crude oil price volatility. Ted Jenvey, Gazebo's portfolio architect, however, accounts for this by saying that the Gazebo models pick "supercharged" stocks—the ones that move the most with respect to the underlying metric. If we don't supercharge, we don't get the payoff function we want."

Don't care about oil prices? Not to worry, says Gazebo President Laurie Conner, "There are over two dozen IBI portfolio pairs. With IBI, investors can stay invested in a sector, an indicator, or an individual stock, whether rising or falling, without leverage, margin or time constraints, simply by switching between bullish and bearish portfolios."

Figure 3

Gazebo's IBI Bullish and Bearish Portfolio Pairs
Economic Indicators	Commodities	Sectors	Individual Stocks	International Stocks
Dow Jones Industrial Average	Brent Crude Oil	Biotechnology	Amgen (AMGN)	Mexico
Nasdaq Composite Index	Gold	Computers	AOL Time Warner (AOL)	Japan
Fannie Mae	Natural Gas	Financial	Apple (AAPL)
Long Interest Rates		Retail	Cisco (CSCO)
Short Interest Rates		Semiconductors	CitiGroup (C)
		Telecomunications	General Electric (GE)
		Utilities	Microsoft (MSFT)
			Yahoo (YHOO)

Gazebo's individual stock portfolios, too, may challenge single-stock futures and equity options for a chunk of hedge business. Employing Gazebo's bearish portfolios in lieu of long puts, short calls, synthetics or short futures, effectively swaps exposures to Greeks and to roll costs for tracking error.

And, depending upon your perspective, tracking error can be a help or a hindrance. Both the Gazebo bullish and bearish AOL portfolios, for example, gained ground over the five- year period ending in 2001, but not nearly to the extent of AOL itself, as illustrated in Figure 5.

Figure 5

While AOL averaged a 265 percent annual return over the five-year period, the Gazebo bullish and bearish portfolios cranked out average annual gains of 21 percent and 17 percent respectively.

Figure 6

	AOL	Bullish Portfolio	Bearish Portfolio
Annual Return Volatility r2 Beta Alpha	264.45% 61.77% - - -	21.09% 54.80% .35 .52 -1.19	17.27% 14.40% .00 .00 .13

The seemingly large tracking error may, in fact, be an artifact of the multi-factor analytical model used to derive the IBI portfolio.

Is it possible that Gazebo's multi-factor model latched onto and simulated the true intrinsic value of AOL, while filtering out the pervasive headiness of the tech market bubble? If that's the case, then IBI portfolios may not only be useful as investing or hedging tools, but may also be bellweathers of stock value.

And with that in mind, I wonder what the Enron portfolios might have looked like?

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.