AUGUST 1, Trade at Index Close SUBMITTED BY. Kelly Haughton and Joseph Smith Russell Investments

Transcription

1 AUGUST 1, 2008 Trade at Index Close SUBMITTED BY Kelly Haughton and Joseph Smith Russell Investments

2 AUGUST 1, 2008 Trade at Index Close In the US equity trading arena, advances in financial engineering and technology have resulted in the creation of innovative products and trading techniques that can better serve institutional clients, portfolio managers, and active trading desks. The emergence of the financial futures market in the late 1970s marked a monumental shift in how investors gain market exposure, conduct hedging activities, manage cash flows, and speculate on future short-term market movements. Even with these innovations in equity trading, there has been an increasing need for a better mechanism to allow institutional investors to efficiently move between the physical and derivative forms of market exposure. The InterContinental Exchange (The ICE), a leader in innovation in the futures market, is offering new order type to trade Russell US index futures (e.g. Russell 1000, Russell 1000 Value, Russell 1000 Growth, Russell 2000 ) which trade exclusively on its exchange. This new order type, Trade at Index Close (TIC), provides a more cost effective way for portfolio managers, market makers, ETF Authorized Participants (AP), and speculators to trade index futures contracts and meet their short-term investment needs. More importantly, the TIC order type can better facilitate the shift between physicals and derivatives for portfolios that track Russell indexes. This paper outlines how the TIC order type works, as well as its advantages, benefits, and potential applications in the marketplace. Trade at Index Close.how does it work? The TIC order type represents an unprecedented way for investors to buy and sell index futures contracts on a major exchange. Unlike the traditional order types that exist, the TIC order allows investors and traders to buy and sell Russell index futures contracts with prices based on the equity market end-of-day closing price of the index. Market participants can place buy or sell TIC orders on Russell index futures contracts at any point during the day before the market close. The ICE manages the clearinghouse activities by matching buy and sell TIC orders throughout the day. Upon market close, each party involved transacts in the index futures market with a price determined as being the closing index value plus basis of the Russell index upon which the contract is based, multiplied by the value per contract, plus basis. Generally, institutional investors have a fair value estimate that helps determine what basis away from the closing index value at which they are willing to transact. After the trade is settled, the normal marking-to-market, margin, and settlement activities occur in each party s account over the life of the index futures contract.

3 Advantages and Benefits of the Trade at Index Close Order Index futures contracts represent one of three popular options available to investors to gain or hedge their exposure to the equity markets. The other two are direct investment in equity securities or by entering into an equity swap agreement with counter-party in the over-thecounter (OTC) market. As shown in Exhibit 1, index futures are used in a variety of ways by different market participants. Index funds, active funds, and hedge funds use Russell index futures as a way to create synthetic equity portfolios, manage cash flows, and hedge their market risk if necessary. Broker-dealers, transition managers, market makers, and ETF APs utilize Russell index futures to hedge their exposure to market movements while providing liquidity for the securities held on their books. Arbitrageurs, speculators, and short-term traders find Russell index futures a cost effective way to gain quick market exposure and take advantage of any temporary mis-pricings or short term opportunities in the equity markets. The TIC order type provides investors with another tool to help meet their investment needs but also creates a more efficient mechanism to manage the transition between equity securities and equity derivatives that replicate Russell index exposure. Exhibit 1: Users and Their Application of Russell Index Futures Portfolio managers take in daily cash flows from new investment by investors and any dividends that are paid by the companies represented as securities in their portfolios. They must manage their cash flows and equitize them to avoid a drag on their returns from simply holding cash. Typically, these cash flows are received by the end of the trading day. In the case of index fund managers, equitizing cash flows as soon as they are taken in is a critical PAGE 2 OF 6

4 part of ensuring the portfolio tracks its target benchmark efficiently. Index futures and other index derivatives have provided a low cost way for portfolio managers to equitize their cash flows quickly. In contrast to having to wait until the cash flows are finally received before equitizing them, the TIC order type provides a more efficient way to equitize incoming cash flows by giving portfolio managers the flexibility to place orders throughout the day to acquire index futures at end of day pricing. This not only alleviates the pressure of ensuring that there is minimal amount of cash drag, but also provides certainty as to the pricing the portfolio manager will receive on the basket of index futures he or she is acquiring. Portfolio managers are able to anticipate when they will have dividends and other cash flows coming into their portfolios and must ensure that those cash flows are invested in a timely manner. The TIC almost guarantees that you will get fair value pricing for index futures and help ensure there is no drag on returns in your portfolio. Steven Tong, CalSTRS Investors who use derivatives as tools in risk management can also use the TIC order to hedge portfolios more efficiently. Hedging a position or portfolio involves an investor going long or short a basket of securities and simultaneously entering into an offsetting transaction with some type of derivative. This practice is meant to ensure that a portfolio is not theoretically exposed to general market risk and short-term movements. Investors can buy or sell a basket of securities in the equity markets using a market at close (MOC) order to guarantee end-ofday pricing on the securities they hold or want to acquire. The problem investors experience with attempting to hedge their portfolios is that most equity derivative instruments do not offer trading capabilities to lock in the price at which they bought or sold the original basket of securities to complete the hedge. An investor looking to hedge their portfolio with equity index futures can overcome this issue by using a TIC order type. The unique benefit of the TIC order is that it allows investors to trade Russell index futures at prices that coincide with the pricing they would expect to receive on a basket of equity securities using a MOC order. Having the to capability to trade equity securities and index futures at the same price (as one can do using MOC orders with TIC orders) can help market makers and broker-dealers alike provide better liquidity to their clients and the marketplace while reducing the cost to hedge their market risk. Converting portfolios from physicals to futures, futures to swaps, or swaps to physicals can be costly and cannot be done without incurring some slippage between settlement prices between each market. Most institutional investors currently place exchange for physicals (EFP) orders with a broker-dealer to manage a portfolio s transition from exposure in the equities securities market to the equity futures market and vice versa. With an EFP, an investor is allowed to deliver or receive a basket of securities that make up an index in exchange for a basket of futures contracts on that same index. The investor is exposed, however, to basis risk if there is a mismatch between the pricing characteristics of the physical securities and the underlying index futures. When basis risk is present, the TIC order type can be used as an alternative way for transitioning a portfolio s exposure from physicals to futures. The TIC order type helps to PAGE 3 OF 6

5 minimize this risk because once filled, it guarantees the price the investor will receive in the index futures. Taking advantage of the TIC order, in conjunction with placing MOC orders for baskets of securities same Russell index, will allow for more interchangeability between different forms of equity exposure. This enhanced linkage that the TIC order presents allows for better liquidity in Russell index futures and reduce the trading costs for other forms of market exposure. We are seeing that the dominant players in transition management and overlay services are increasingly moving between market exposures through futures and physicals To compete effectively in overlay services and transitions, you must be able to move efficiently between physicals and futures. The TIC will be another valuable tool to achieve this. Tom Fletcher, Director of Portfolio Management, Russell Implementation Services, Inc. Conclusions The TIC order type allows institutional investors to do trades with reduced transaction risk and likely lower cost. It also provides an unprecedented way for investors to efficiently transition between the physical and derivative markets. The advantages and benefits that the TIC order provides can be a valuable tool that can better serve the needs of many investors. The TIC order type may well replace current best practices for transition management and overlay services in the near future. Potential Applications and Examples of Using a Trade at Index Close Order Cash Flow Management- A Russell 1000 index fund portfolio manager learns at 10:00 AM that the fund is expecting USD 2,000,000 in net cash flows to be coming into the fund at the end of the day when the market closes. The portfolio manager needs a way to equitize his cash flows to ensure the portfolio does not incur any substantial tracking error as a result of the new cash available. Based on their estimate for fair value, the portfolio manager places a buy TIC order with the ICE during the day that will settle based on the ending closing price of the Russell 1000 index. Hedging Activities A broker-dealer is concerned with how the markets are going to be trading overnight and her exposure to the markets. Because of this, she wishes to hedge overnight her inventory of stocks currently on her books which is best represented by a combination of 70% Russell 1000 Growth and 30% Russell 1000 Value. The broker-dealer decides to place a sell TIC order on the ICE for both Russell 1000 Growth and Value index futures contracts. ETF Creations/Redemptions In-Kind An ETF AP that regularly creates and redeems shares in-kind with the ishares Russell 1000 ETF (IWB) needs to create additional ETF shares for redistribution in the secondary marketplace. The AP places a MOC order to acquire the basket of securities needed to deliver to the ETF. To hedge its position and remain flat, the AP also place a TIC sell order with ICE for Russell 1000 index futures. At market close, the AP receives the basket of securities from the MOC transaction, delivers those securities to the PAGE 4 OF 6

6 fund in-kind for more IWB shares, and sells the ETF shares in the secondary marketplace. The AP then uses the proceeds to cover its short position in the Russell 1000 index futures. Minimizing Tracking Error During Russell Reconstitution A Russell 1000 Growth index fund portfolio manager is concerned that there will be considerable volatility in June around Russell s annual index reconstitution and wishes to avoid any tracking error associated with having to buy and sell newly added and deleted securities in the index. On the day before the official reconstitution she decides to place a sell MOC order and place a buy TIC order on the ICE for the Russell 1000 Growth futures contracts that will expire in September. This transaction will allow her to perfectly shift her portfolio from holding the actual securities to creating a fully synthetic portfolio. On the day of expiration for the futures contract, the portfolio manager places a MOC buy order for a basket of Russell 1000 Growth securities. At the end of the day she receives from the settlement of the futures contract the proceeds, uses the proceeds to settle the MOC order, and receives a basket of securities on the Russell 1000 Growth which reflects the most recent changes resulting from the reconstitution. PAGE 5 OF 6

7 About Russell: Russell Investments provides strategic advice, world-class implementation, state-of-the-art performance benchmarks and a range of institutional-quality investment products. With nearly $211 billion in assets under management (as of 6/30/2008), Russell serves individual, institutional and advisor clients in more than 40 countries. Russell provides access to some of the world s best money managers. It helps investors put this access to work in corporate defined benefit and defined contribution plans, and in the life savings of individual investors. Founded in 1936, Russell is a subsidiary of Northwestern Mutual Life Insurance Company and headquartered in Tacoma, Wash. Russell has principal offices in Amsterdam, Auckland, Johannesburg, London, Melbourne, New York, Paris, San Francisco, Singapore, Sydney, Tokyo and Toronto. About Russell Indexes: Russell s comprehensive family of global equity indexes, including the industry-leading Russell U.S. indexes, allow investors to seamlessly track performance of distinct market segments worldwide without gaps or overlaps. Russell s index story began in 1984 when the multi-manager investment firm launched its family of U.S. indexes to accurately measure U.S. market segments and better track investment manager behavior. These indexes have become the most widely used benchmarks by institutional investors and today about $4 trillion in assets are benchmarked to them. In early 2007, Russell applied the same pioneering index methodology to the world s equity markets to create the Russell Global Index and hundreds of subcomponent global indexes that capture 98% of the investable global equity market. PAGE 6 OF 6

8 Russell Investments, a USA corporation which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks and copyrights related to its indexes. Indexes are unmanaged and cannot be invested in directly. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. NEITHER FRANK RUSSELL COMPANY'S PUBLICATION OF THE RUSSEL US INDEXES NOR ITS LICENSING OF ITS TRADEMARKS FOR USE IN CONNECTION WITH SECURITIES OR OTHER FINANCIAL PRODUCTS DERIVED FROM A RUSSELL US INDEX IN ANY WAY SUGGESTS OR IMPLIES A REPRESENTATION OR OPINION BY FRANK RUSSELL COMPANY, INTERCONTINTALEXCHANGE, INC. OR ANY OF THEIR RESPECTIVE SUBSIDIARIES AS TO THE ATTRACTIVENESS OF INVESTMENT IN ANY SECURITIES OR OTHER FINANCIAL PRODUCTS BASED UPON OR DERIVED FROM ANY RUSSELL US INDEX. FRANK RUSSELL COMPANY, OR ANY OF ITS SUBSIDIARIES ARE NOT THE ISSUER OF ANY SUCH SECURITIES OR OTHER FINANCIAL PRODUCTS AND MAKE NO EXPRESS OR IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE WITH RESPECT TO ANY RUSSELL US INDEX OR ANY DATA INCLUDED OR REFLECTED THEREIN, NOR AS TO RESULTS TO BE OBTAINED BY ANY PERSON OR ANY ENTITY FROM THE USE OF THE RUSSELL US INDEX OR ANY DATA INCLUDED OR REFLECTED THEREIN. Copyright Russell Investments CORP-5512