Equity index futures are used by nearly every type of institutional investor to dial up or down beta, to hedge risk, and to equitize cash, but there’s a cost for that leverage embedded in future prices – and not all futures users optimize around those costs. With quarterly futures in play – December contracts expired when the markets opened on December 18 – portfolio managers and traders may be thinking about when and if to roll their positions.
II recently spoke with Kristy Akullian, Head of Markets and Trading Strategy, BlackRock iShares, about what you can expect of the December-March roll, which has historically been the most expensive of the calendar year.
What’s your take on where roll costs for this December-March period?
Akullian: The S&P 500 is quite rich to fair value, and we see that trend continuing across the other exposures that we cover as well. The Russell 2000 typically trades cheap to fair value, which is pretty unusual because almost everything has a bit of a long bias. But Russell, because of the demand to short the index because it’s high beta, typically trades at a sub-LIBOR level – but even that we see trading at about 30 basis points rich to LIBOR.1
The same thing is happening in the emerging markets and EAFE [Europe, Australasia, Far East] space, which are the two big MSCI composite indices that investors tend to look at, and both of those are quite a bit richer than they were last quarter. They may actually richen a bit more at expiry, but it’s difficult to say at the moment.
Overall, do you expect to see a richening or a cheapening trend into expiry?
Akullian: That’s the $1 million question every quarter. In December, the more hoopla around year-end funding pressures and balance sheet, the more people pre-position ahead of it. So, the hoopla doesn’t necessarily become manifest. People have been focused on a lot of different things this year leading up to the roll, and the richness of it surprised a lot of people relative to last quarter. Usually, when that happens, we tend to see the richness peak a little bit earlier on, and then fall off a little bit as we go into expiry. But as nice as that sounds from a long-rollers perspective, I always caution that those last two days prior to expiry are like the Wild West. Anything can happen – it’s on pretty thin liquidity, so we tend to see really big moves either richen or cheapen just in those last two days.
There’s a conventional wisdom that hedge funds tend to roll later in the cycle than other asset managers and asset owners do. Since they tend to be short, sometimes they come in and push the roll down, and it will tend to cheapen a little bit. I don’t know if that’s still always true, but that’s the folklore. However, we always caution people to trade in line with volume. You don’t want to be caught on the wrong side of those Wild West big moves and thin liquidity.
Let’s turn to the year-end premium in the derivatives space. What causes that and how investors can think about avoiding it?
Akullian: Typically, what we see is that balance sheet becomes pretty expensive. It’s pretty scarce and there’s a lot of incentives for banks, especially U.S. institutions, to clean up their balance sheet heading into year-end – they want to look as strong and healthy as possible before regulators take their look. So, when you see balance sheet get a little bit tighter it also tends to get a bit more expensive. That can ripple through the synthetic products, and in anything where you’re using a bank’s balance sheet expect it to be a bit more expensive in December than, for example, it might be in January or March.
In March, many of the mainstays of the liquidity market froze at a time when institutions were looking for liquidity. What was the role of ETFs during that time?
Akullian: One interesting metric that we’ve looked to, especially during periods of volatility, is the percentage of total trading comprised of ETFs. Typically, if we use 2019, we saw that ETFs were around 27% of total trading.2 In March and April [2020] we saw that not only did total ETF trading go up, but the proportion of ETFs versus everything else went up as well. We saw ETFs trading as much as 40% of the total equity market, which is a strong signal to us that a lot of investors were using them as a risk transfer tool in a way that maybe they would have used futures in the past. ETFs have come into their own and many are so large and liquid that we see a lot of different types of investors use them as well.3
Another observation along the same lines: In the March-April period, and then again over the summer, ETFs served as a sort of a meeting place. The price action was coming from either institutional investors or from a new cohort of retail investors – the Robin Hoodies – and they were trading in opposite directions. Because ETFs can be both a retail and an institutional tool they allowed those two groups to sometimes meet in the middle, and we saw a lot of natural two-way flow. That contributed to a lot of the higher volumes too.
How has equity market volatility this year has affected how people think about index exposure?
Akullian: We saw really extreme levels of richness and cheapness, for example, in futures in March and April. To be completely frank, I don’t think institutional investors minded too much. When you have the index and the market’s moving 12% in a day, even if something is a percent rich or cheap here and there, you’re likely to think “Let’s just put on this exposure” or “Let’s put on this hedge.”4 And you’re very desensitized in terms of costs.
What we’ve seen since then has been a little different from a typical year. The volatility has served to dampen some of the roll costs from what they would have otherwise looked like, so synthetic products were probably a bit cheaper this year than they would have been at similar levels of index performance, for example. A useful heuristic that is that the cost of synthetic exposure or the cost of leverage tends to move pretty much in lockstep with however the index is doing. If the index is up, you tend to see more long rollers and more long positioning in general. Positioning tends to follow performance. But this year, even though we’re hitting new highs in terms of index levels, volatility has still been a lot higher than normal, and we’re seeing some cases of once bit, twice shy. As a result, there’s a lot more hedging activity via index exposures than we would typically see in periods when the market’s doing really well. So, we’re seeing a higher short base in a lot of synthetic products, and in futures positioning in particular, which brought down some of the costs and made it a little bit more of a natural two-way flow. We’ll see what that does going forward, and where the index moves.
BlackRock has worked with institutional clients over many years to determine the most efficient way to get index exposure. What has that experience revealed?
Akullian: That the best vehicle for achieving that exposure changes by asset class, exposure, and over time. That’s why it’s important to have a dynamic monitoring processing in place for futures roll costs. We’ve also found the cost can vary significantly by investor mandate, making customization a key aspect of any analysis. Those are some topline learnings that led to the development of the BlackRock Delta One tool, which is designed to help investors compare the costs of index replication via futures and ETFs.
You mentioned the BlackRock Delta One Tool. Who stands to get the most out of the type of analysis offered by the tool?
Akullian: When we built it, the idea was to thread that needle of being useful from both a portfolio management perspective and also from a trading perspective. As we’ve rolled it out to institutional clients, we’ve seen that it can serve as a bridge between those two. For example, a portfolio manager may say, “I need exposure to this index and this size.” And then give the discretion to the trader in terms vehicle selection. Sometimes a portfolio manager sends a trade order to specifically buy and sell X amount of futures contracts, and the tool can help both of them speak the same language, and that is quite helpful because vehicle selection typically sits somewhere between portfolio management and trading with no clear ownership. Even within BlackRock, we see variations depending on the PM and whomever is trading the PM’s book. Delta One introduces a common language and a place that everybody can meet and understand each other’s perspective.
The tool is about a year old now. Do you see a lot of asset owners using it?
Akullian: We do, particularly in the pension space for example, maybe because of their size, have always gravitated towards liquidity and futures without effectively calculating – or at least putting pen to paper on – what the trade-offs could be in those costs.
For access to BlackRock’s Delta One Tool and other tools for institutional investors, visit iShares.com.
1. Bloomberg, BlackRock as of December 10, 2020.
2. Bloomberg, BlackRock as of December 31, 2019.
3. Bloomberg, BlackRock as of March 31, 2020.
4. Bloomberg, as of March 31, 2020.
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