A simple explaination of index replication
The introduction of equity index futures in 1982 opened a new door for passive index investors by giving them an effective, efficient tool to replicate their core beta while allowing them to retain cash for operational and alpha- generating purposes. This type of investment strategy is commonly employed and outlined in the prospectus disclosures of indexed mutual funds and ETFs. Investors
can use futures to establish their benchmark equity index exposure, benefit from the leverage and use the freed-up capital to deploy alpha-generating strategies.
With the launch and development of CME Bitcoin futures (BTC), which in July 2018 averaged over 6,200 contracts per day (approximately 31,000 equivalent bitcoins; +$230 million in notional value 1 ), the strategy can be easily adapted by crypto-fund managers.
Consider a crypto fund manager of an $8 million fund that is benchmarked to the CME CF Bitcoin Reference Rate (BRR). She wants to replicate 100% of the fund’s value in BTC futures and retain cash for income-generating (alpha) activities.
The manager can use BTC futures which represent the financial equivalent of five -bitcoin in notional value to gain exposure. Futures contracts do not require full payment of notional value prior to purchase. They require performance bond, also known as margin, for open positions. If we assume BTC is at $8,000 per bitcoin and the margin on one BTC contract is $17,2002, a beta replication strategy can be constructed. The manager can obtain the desired exposure by buying the notionally equivalent number of futures and using the excess capital to invest in interest bearing securities.
For example, the crypto fund manager who wants to replicate 100% of her fund using BTC calculates the notional value of one BTC contract:
NV (BTC) = $8,000 per bitcoin x 5 bitcoin = $40,000 per contract
Thus, $8,000,000 / $40,000 = 200 BTC contracts to replicate 100% exposure, keeping the fund fully exposed to its benchmark. Two hundred BTC contracts require $3,440,000 in margin to CME Clearing (200 x $17,200) allowing the manager to employ the remaining balance of $4,560,000 in cash to alpha-seeking investments.
Assume over the course of a year that the BRR trades off by 5% to roughly 7,600. The fund loses 5% of its value, a
$400,000 loss. If the cash funds invested in money market equivalents earned 2% interest 3, they would have produced
$91,200 in income for the fund. Subtracting the $91,200 income from the $400,000 produces a loss of $308,800, or 3.9%4 loss, rather than 5.0 %. In other words, the fund beat the index benchmark (and potential competitors) by 1.1%.
Would that improvement over benchmark make a difference to the fund’s investors or potential investors? Looking at how equity index futures influenced the growth of index funds, it is certainly worth investigating how CME Bitcoin futures might be used by crypto funds for BRR beta replication.
Read original article: https://cattlemensharrison.com/using-cme-bitcoin-futures-for-crypto-fund-managers/
By: CME Group