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Asset allocation using derivatives

Kshama Fernandes

Asset allocation is one buzzword from the investment world. Often, we hear the terms "strategic asset allocation" or "tactical asset allocation". Strategic asset allocation is a long-term plan while tactical asset allocation refers to a short-term plan. But before we go into details of these plans, let's talk about what asset allocation is really about.

In asset allocation, an investor decides how to divide funds among broad asset classes. For example, the decision to invest 60 per cent in equities and 40 per cent in treasury bills (T-bill) is an asset allocation decision. The choice between investing in Infosys and Satyam is not an asset allocation decision. Thus, asset allocation focuses on the macro level commitment of funds to various asset classes and the shifting of funds among these major asset classes.

In an asset allocation strategy, the universe of available investments is divided into classes such as domestic stocks, international stocks, domestic bonds, international bonds, cash and real estate. The number of classes is a function of how distinct you want the classes, and, whether you are permitted to invest in certain types of assets. An asset allocator does not select individual component investments within a given asset class. Rather he decides on an overall allocation across classes. One could think of asset allocation as an attempt to time the market by being in the best performing classes and out of the worst at the right time.

Strategic asset allocation defines the percentages that the allocator attempts to maintain over a longer period of time. Tactical asset allocation defines the short and intermediate term percentages. The million dollar question is: After all the hard work that these asset allocators do by way of using a variety of macroeconomic and financial tools to provide signals and determine allocations, do they really succeed in outperforming a simple buy and hold strategy? This is actually asking whether active management pays. Although I am a little sceptical, I see no reason why an investor should not periodically reallocate his portfolio if he has access to easy and cheap techniques to alter his exposure to the various asset classes. Derivatives enable him to do just this, that is, alter his exposure in a way that is easy and cheap.

In an earlier article we had discussed the cost-of-carry model for futures pricing. In this article we shall again use the same basic cost-of-carry model to show how a trader can radically adjust an initial portfolio to move from equities to T-bills or from T-bills to equities by using stock index futures.

The basic cost-of-carry model we used earlier asserts that the futures price equals the spot price times one plus the cost-of-carry under suitable market conditions:

F = S (1 + C)

where F = the futures price at t=0

S = the spot price at t=0

C = the percentage cost of carrying the spot good from t=0 to the futures expiration.

The cost-of-carry includes the financing cost of purchasing the asset, plus storage, insurance, and transportation. In the case of financial futures, the cost-of-carry essentially equals the financing cost, because storage, insurance, and transportation are negligible. Therefore, a cash-and-carry strategy of selling a futures and buying and holding the spot good until the futures expires should earn the financing rate, which essentially equals the risk-free rate of interest.

An example will make it clearer. We consider the case of an investor who has a percentage invested in stocks, which can be roughly approximated by the S&P CNX Nifty index. The remaining percentage is invested in cash, as reflected in a money market fund rate. Think of the situation where the investor would like to decrease the allocation to stocks. This could be done by selling off some stock and putting the funds into cash. But there's a small problem in doing this. The sale of the stock could result in sizable transactions costs. If the investor considers changing the allocation again in the near future, the round trip transaction cost will probably wipe out any gains he might make out of the deal. Index futures can help him do the job quite easily and effectively.

Let's elaborate on the cash-and-carry strategy we spoke of above. The basic principle is that a long position in stocks and a short position in futures is equal to a long position in cash. Of course, remember the assumption we made above, that the underlying index for the futures matches the stocks. If this is true, then the investor can sell futures against a portion of the stocks. For example, if the investor wanted to reduce his risk by 20 per cent, he could sell futures with a face value equal to 20 per cent of the stocks he owns. Thus, 20 per cent of his stocks would be matched with futures contracts. What he is basically doing is pre-selling the 20 per cent stock using futures. The sale price of the stocks is locked in. To the extent futures are correctly priced, the stock is hedged for a return of the risk-free rate, which should pretty much match the money market return.

By using the above strategy, the trader creates a synthetic T-bill by holding stock and selling futures.

Synthetic T-bill = Stock - Stock Index Futures

This could be done in the other direction as well. Consider a trader who holds all assets in T-bills. We assume that this trader expects a stock market surge, and would like to take advantage of the rising stock prices. However, she is reluctant to incur all the transaction costs associated with buying stocks. She too can implement her asset allocation decision by using stock index futures. An investor who wants to increase the allocation of stock can buy futures. This replicates the process of borrowing at the risk-free rate to purchase additional stocks.

By using this strategy, the trader creates a synthetic stock portfolio by holding T-bills and buying stock index futures.

Synthetic Stock Portfolio = T-bills + Stock Index Futures

The same principle can be used for a portfolio of domestic securities that needs to be reallocated to include some international exposure (assuming you have access to international markets). For example, suppose you held only the S&P CNX Nifty stocks and wanted some exposure to the US markets. All you need do is sell some amount of S&P CNX Nifty futures and buy S&P 500 futures.

Futures are not the only derivatives that can be used. Options too work similarly. However since an option's risk changes continuously, asset allocation using options requires continuous monitoring and adjustments. This is not to say that a futures strategy will work perfectly to reset the effective allocation to the desired allocation. There is the basis risk to deal with. Besides, futures require daily mark-to-market settlements, which can produce losses that require cash deposits. There is also the possibility of futures mispricing, which could result in a return lower than the risk-free return.

Having said this, there is no doubt that use of derivatives can make asset allocation easier to handle. Besides, the savings made on the transactions cost are tempting enough to give it a try.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

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