Deutsche Bank London takes a 360 degree view of the MSCI Index Options and Futures – Part 1

In an interview, Pam Finelli and Fadi Chamsy from Deutsche Bank’s synthetics team explored on the MSCI derivatives from different angles. The first session of our 2-part interview focuses on how the Eurex MSCI offering fits into Deutsche Bank’s business landscape, on crucial trading strategies and the benefits of on screen trading.

In the second session, Pam and Fadi will tell us where they see the potential of the products with respect to regulatory aspects and the market climate in general. Click here to get there.

Eurex: Thanks for sitting down with us today. Could you please start by giving us a bit of background about yourself and your team?

Fadi: I’ve been at DB for a bit more than five years. I initially joined from banking to work in the special situations business, but I have moved to more of a synthetic equity role over the years, as DB has started to focus on synthetic equity more from a sales, trading and research perspective. The synthetics team, which is headed by Pam Finelli, was put together a couple of years ago. The team performs research on various synthetic instruments, be it ETFs, swaps, or futures. We believe we are in a unique position on the street providing clients with analysis on optimising the implementation of their equity investment decisions by helping them understand different synthetic wrappers and select the wrapper best suited for their investment criteria. Many of our clients are benchmarked to MSCI indexes making them a big focal point of our research.

Eurex: How do Eurex derivatives fit into the landscape and into your business?

Fadi: The big question for a lot of investors is finding the best way to gain exposure to a specific benchmark. This is true for any benchmark index that an investor may track but the rise of MSCI derivatives recently has increased the debate about the best way to gain exposure to MSCI benchmarks. When working with clients, we will consider all synthetic wrappers available to the client and help him understand the benefits and drawbacks of each and ultimately select the instrument which suits his investment style best.

Traditionally many investors constructed baskets of stocks or futures to track an index. For instance, tracking MSCI World would be achieved using an optimised basket of the three to five most liquid underlying local market futures. This introduces a tracking error, slippage and execution risk.

These can be manageable in stable market conditions when volatility is low and this strategy worked well up to 2008. When market volatility increased sharply, tracking error and more importantly slippage was very high. We saw that in September 2008 and then again in August 2011, when the tracking error for a basket of six local market futures tracking the MSCI Emerging Markets (EM) shot up from three to eight percent.

What we’ve seen since is that investors are more concerned with minimizing their tracking errors and that is exactly what the Eurex MSCI derivatives offer: the capability to trade one single instrument with near zero tracking error. Investors no longer need to manage their beta and can focus on alpha generation.

Obviously there are other instruments that also combine good tracking with ease of trading. Traditionally, swaps have been the most straightforward way of gaining exposure to an index. Swaps are OTC products which offer near-perfect tracking without the need to manage the risk, the rebalancing, etc. It’s all outsourced to the swap counterparty. ETFs have gained popularity in the last decade. These are listed products so they appeal to a different investor base, but again they are ultimately a different wrapper for the same product albeit with different funding requirements. When we compare these different instruments, the main consideration is who the client is, what their restrictions are from a regulatory point of view, what they’re allowed to trade, and what they’re comfortable with. The cost may vary depending on your investment horizon and trading strategy. Based on these factors, we can analyse what the best wrapper is for each client. In this context, we have seen growing interest in MSCI derivatives which now that they are listed appeal to a much larger investor base.

Eurex: Going back on a point you made earlier about tracking errors – do you see a tipping point where liquidity in the broad benchmark itself becomes so good that clients are no longer willing to accept the errors that come with basket solutions?

Fadi: It’s very difficult to answer this question. We’ve seen the mini futures in the U.S. trade very healthy volumes, but I don’t think we’ll get to a point where screen liquidity will actually overtake or reach the same level as some of the very liquid futures, e.g. S&P or EURO STOXX®. So there will always be investors who would rather trade a basket, who are typically less tracking-error sensitive. It ultimately depends on the type of investor; if having perfect tracking is the most important thing, liquidity takes a back seat. If you’re looking for directional exposure or hedging, you don’t worry too much about the tracking error. So I don’t think we’ll get to a point where no one uses baskets anymore.

Eurex: So you’d go for one or the other.

Fadi: Exactly. Obviously the more liquid the product becomes; the more tracking-error sensitive investors will be inclined to use it. But you will still have a different investor base that will still be looking to replicate the benchmark with baskets of futures.

Eurex: Could you please describe some of the strategies where MSCI products play a crucial role?

Fadi: There are three key parts. The first is liquidity management. For an investor replicating a benchmark by holding a portfolio of the underlying stocks, periodically switching part of the portfolio into futures allows the investor to maintain the same level of exposure to the benchmark while releasing cash typically for dividend reinvestment or other corporate actions treatment.

The second thing is beta exposure. This is probably more suitable for people who are looking for fast exposure. Let’s assume the market has rallied and you as an investor are underweight equities or underweight a specific region. Increasing your allocation using futures is a fast an efficient strategy which does not require full capital

In these two scenarios, using a basket of futures, which has traditionally been the most common strategy, introduces a tracking error and some investors may prefer to use a single listed instrument. However, liquidity is also a major factor as investors are often looking to shift large amounts of notional investment over very short periods of time.

The third strategy, and this is where we have seen most interest in MSCI derivatives, is hedging. This can be hedging a long actively managed portfolio which is benchmarked to an MSCI index or reducing the beta exposure of a portfolio if an investor feels he is overweight. We have seen increased activity in the use of MSCI futures on this front. Options have only been recently listed and liquidity will take some time to pick up though on OTC market has existed for many years.

Eurex: Do you see an increasing number of institutional clients attracted by opportunities to use MSCI index products as part of a hedging strategy?

Fadi: In terms of popular hedging strategies, over the last six months to a year we’ve seen a lot of investors selling futures and buying puts and put-spreads on the options market.

Eurex: In terms of the different products available, on Eurex Exchange and also on Liffe’s BClear platform, could you outline what you feel are the merits of each?

Fadi: Both have their merits. With regards to centralized clearing of OTC instruments, they offer flexibility while also removing the counterparty exposure.
The Eurex offering has added a centralized orderbook, Market-Making, and the ability to see a price on screen which investors value a lot. The key question is: will investors be trading these instruments on screen? Our answer is probably not exclusively. The main utility of the screen price is the ability to continuously see where market levels are in order to get a better handle on price and on mark-to-market valuation. While this is the key difference, the ability to cross-margin positions across other Eurex derivatives and the CFTC approval adds to the appeal of the Eurex products to certain investors.

While we stress on the importance of screen pricing, we think that the block trading facility will continue to be the way people trade, simply because Market Makers may never quote very large clips. Investors trading around a position and adjusting their exposure can trade small clips on screen. But for large size, trading on block can guarantee swift execution, transparent pricing and fixed levels (typically the index close). This benefits both the investor who can track the position to an index close level and the dealer who can hedge the position in the underlying cash market at pre-agreed levels.

The other thing which is often overlooked is the difference between MSCI indexes and the local market indexes. MSCI indexes are regional indexes which cover several markets that can span over a number of time zones. The level of the index is calculated based on the level of the underlying markets at each point in time. If a market is closed, the index level will reflect the closing level whereas the future may reflect market movements post close. The cost - or basis - of a local country future is the generally the difference between the index level and the futures level at any point in time.

However, for an index such as MSCI Emerging Markets, the difference between the levels of the future and index is not necessarily the cost of the future. Eurex MSCI EM Futures for instance trade European hours when most EM markets are closed. The level of the future therefore incorporates both the cost of the future and the implied level of the underlying markets.

The dealer is ultimately responsible to provide different components that make up the price. This is another attractive feature of the block trade. The trading level is pre-agreed and the cost is transparent.

Eurex: And that’s down to the nature of the underlying product?

Fadi: Exactly. These are regional indexes, there are many underlying markets over a number of different time zones. We have only started to value them recently and many clients who have less resources to analyse these instruments will perhaps struggle more. So it’s an educational process, a self fulfilling loop – as people become more comfortable, liquidity increases – but it will take time.

Eurex: Thank you very much for the conversation.