With increasing focus on sector-based investment strategies, most notably in Europe, but also on a global level, implementation of these decisions is still mostly done at the stock level. This is in contrast to country-based investment decisions – globally, investors are avid users of country-index based derivatives. During the third quarter of 1999 equity index futures based on country indexes traded $83bn a day (compared with $77bn in the underlying stock markets). Sector-oriented index futures traded a small fraction of this in the US, and hardly exist in Europe.
Trading sector views using individual stocks is time-consuming, and also clearly increases the stock-specific component of the sector view. Alternatives that we have developed are sector index certificates, swaps and options. The certificates and swaps both give investors access to 100% of the upside (or downside) of the underlying index.
Index certificates are exchange-traded instruments which trade near the value of the index (with some adjustments for expected dividends, funding and issuance costs). They do not provide any element of leverage. Swaps, by contrast, are over-the-counter agreements that do not require commitment of capital up front, but are typically structured to pay the return on a sector index in exchange for a Libor-based return. These instruments have the following advantages, when compared with expressing a sector view using a basket of stocks:
q Pure expression of sector view. Using a small number of stocks to represent a view on a particular sector inevitably involves taking stock-specific risk. In other words, it requires the investor not only to select a sector, but also to extend this to select stocks that reflect the sector view. Trading a larger number of stocks can reduce the stock-specific component of the view, but increases the complexity of trading. Monitoring performance of a particular view is also much simpler using a pure sector-based instrument.
q Simplicity. Sector index certificates are exchange-listed, and require one trade to express a view. As such, they are comparatively simple to trade and settle. They also enable rapid implementation of sector views, and so enable short-term views on a sector to be implemented, possibly with the objective of switching into stock positions over time. Swaps require over-the-counter documentation and so are somewhat more time-consuming to document and settle.
q Ability to take short positions. Sector index certificates and swaps can both be structured to take short positions as well as long side positions. Index certificates can be created whose value decreases when the index increases, and vice-versa. Swaps can implement short strategies more directly.
These benefits must be weighed up against the two principal disadvantages of this type of instrument: first that there can be a cost associated with certificates or swaps, because they use the broker’s balance sheet to fund the purchase of stocks, and second that the user of the instrument is exposed to the credit of the issuer.
The figure illustrates the mechanics of a certificate or swap position. The user of the certificate is shielded from the complexities of trading across a number of markets, including foreign exchange and stock trading and the need to keep track of developments in the index.
Sandy Rattray is executive director, equity derivatives research, at Goldman Sachs International in London