Understanding the CME Liquidity Tool Methodology

Different sectors of the economy respond differently to economic and geo-political news. Some sectors may either outperform or underperform others due to market-moving news or perceived changes in future economic behavior.

The first half of 2018 has provided equity investors with price action in both directions. The following analysis will look at two examples that consider the effects of lower and higher equity index prices.

This analysis will use E-mini S&P Select Sector futures as the sector rotation tool. Select Sector futures are similar to other equity index products that trade at CME, where the futures contract notional value (NV) is based on the index value and the contract multiplier. The notional value (NV) of a Select Sector futures contract can be reflected as:

NV = Select Sector futures index price x multiplier²

To calculate the number of futures contracts necessary to affect the sector rotation within a portfolio take the Adjustment Value (AV) in dollar terms and divide by the NV of the Select Sector futures contract. The Adjustment Value (AV) can be reflected as:

AV = percentage of adjustment x total value of portfolio

The number of futures contracts to be effectuated in the rotation would then be the AV divided by the NV of the Select Sector futures contract:

Contracts needed = AV ÷ NV of Select Sector futures

The following two case studies will evaluate a $1 billion total equity portfolio benchmarked to the S&P 500 Index, and will consider the effects of a five percent adjustment from one sector to another.

Coming into March 2018, the S&P 500 Index had already experienced a 10 percent sell-off in late January to early February. By early March, the index had recovered 7.7 percent of the January-February losses but was struggling to go higher. Assume a portfolio manager wanted to rotate into a more market defensive posture by tilting her position our of financials and into the lower-beta Utilities sector. On March 9, 2018 the portfolio manager identifies a 5 percent rotation as appropriate.

AV = 5% x $1 billion = $50 million

Rotation Overlay Set-Up

Data Source: Bloomberg, CME Group

The table above multiplies each Select Sector index value by its respective contract multiplier to determine the contract’s NV which is then divided into the AV to arrive at the number of futures contracts to use on each side of the sector rotation.

Therefore, for the portfolio manager to achieve the desired 5% rotation out of Financials and into Utilities she would buy 1,015 Utility (XAU) contracts and sell 546 Financial (XAF) contracts.

Over the next month, after the S&P 500 index traded lower but not below February 2018 lows, the portfolio manager decides to unwind the defensive rotation on April 2, to lock in the following results:

Sector Rotation Results

Data Source: Bloomberg

During the time considered, the S&P 500 Index fell by 7.3 percent, while Financials Select Sector (XAF) fell by 9.0 percent, and the Utilities Select Sector (XAU) rose by 2.2 percent. The table below outlines the profit & loss of the Select Sectors futures rotation:

Futures Performance

The Select Sector futures sector rotation made approximately $5.6 million, which will in part, offset the core S&P 500 Indexed portfolio loss of $73 million (-7.3 percent on $1 billion) generating a net loss of $67.4 million instead of the $73 million had no rotation been applied. In other words, the rotation generated 56 basis points of alpha to the portfolio.

By May, the equity market begins to shift its attention towards trade and tariff concerns. On May 3, a portfolio manager decides to tilt his $1 billion portfolio by 5 percent away from trade-sensitive Industrials into the less trade-sensitive Consumer Discretionary sector.

Rotation Overlay Set-Up

Data Source: Bloomberg, CME Group

Using the same mathematics from Case #1 this rotation requires the portfolio manager to sell 697 Industrial (XAI) contracts and buy 483 Consumer Discretionary (XAY) contracts. Despite the stock market’s choppy price fluctuations it trended higher overall from May to early July. On July 10, the portfolio manager decides to exit the rotation strategy and realizes the following results:

Sector Rotation Results

Data Source: Bloomberg

During this period, the S&P 500 rallied 6.2 percent, while both Sectors also rallied but by different degrees. Industrials rallied by +3.0 percent, less than the benchmark index. Consumer Discretionary rallied by 9.2 percent, outperforming the S&P 500 index.

Futures Performance

In this case study, the portfolio enjoyed a gain of 6.2 percent, or $62 million plus an additional gain of roughly $3.1 million from the sector rotation. In other words, the rotation strategy added an additional 31 basis points of alpha to the portfolio.

One of the advantages of using standardized listed futures is the capital efficiency they provide. Compared to a basket of the underlying stocks or a sector ETF which require full payment upon purchase, futures require performance bond, or margin, which is usually a fraction of the notional amount of the contract. For example, the initial margin required for Select Sector futures is approximately 5 percent or less of their notional value.³

Highly correlated off-setting futures positions traded and cleared at CME, like those used in this paper’s case studies, result in lower net margins. Given the sector rotation strategies depicted herein involves buying and selling futures against each other, the resultant positions would be eligible for margin offsets. For example, in Case Study #2, short Industrial Select Sectors and long Consumer Discretionary Select Sectors results in a 67 percent margin break. Effecting the sector rotation strategy via S&P 500 Select sector futures at CME can result in margin offsets that require less capital outlay for the portfolio and potentially increase the return of the portfolio – a benefit that futures provide over other product choices such as stocks, ETFs, or swaps.

E-mini S&P Select Sector futures are an effective tool for sector rotation strategies because of their high correlation to the sector indices and are based on the GICS classification methodology. Investors and market participants can deploy rotation strategies via S&P Select Sector futures to protect against, or capitalize on, market movements and sector dislocation – all without having to liquidate or add to the core portfolio holdings. As exchange traded derivatives they enjoy lower capital charges than ETFs and swaps. Furthermore, dependent upon an investor or participant’s investment scenario select sector futures may be a more cost efficient vehicle – please review CME Group’s total cost analysis framework to understand the savings that sector futures can provide.

1. David Gibbs, “Enhancing Investment Performance of a U.S. Equity Portfolio Utilizing A Sector Rotation Strategy,” CME Group, January 2017

2. Select Sector futures fixed multipliers may be found under contract specifications for each contract: www.cmegroup.com/selectsectors

3. Margins are subject to change. Consult the margin requirements for each Select Sector contract: www.cmegroup.com/selectsectors

Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.

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The information within this communication has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this communication are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and superseded by official CME, CBOT, NYMEX and COMEX rules. Current rules should be consulted in all cases concerning contract specifications.

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