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Efficient Passive Beta

October 2021

Year-end funding pressures have begun to permeate through the prices for unfunded derivatives such as total return swaps and futures. For example, the price of going long S&P500 Total Return is 3m LIBOR + 40bps, far in excess of its long-term average of +20bps. With pricing so elevated, we look at choices available to those who want to invest in equities.

Futures pricing is also elevated

First, it’s important to remember that changes in the overall cost of funding affects both total return swaps and futures. It is easy to forget this given the cost of funding is visible in the price of a total return swap (via the funding leg). This is not the case for futures, where the implied funding is implicit in the basis to the cash market and the quarterly rolls of the contracts.

This chart shows the range of implied funding rates during quarterly rolls over recent years. The implied funding rate moves around during the two weeks when the roll is active, based on the value of the expiring contract and the next-nearest contract. A few things are clear:

  1. Futures implied funding and TRS pricing broadly move in line. The relationship is stronger for 3m swap pricing. This is expected, as the futures rolls themselves capture a 3m window (from the roll to the next quarterly futures expiry)
  2. While swap pricing is quite elevated currently relative to history, so is implied futures pricing. The increase in the cost of funding has affected both instruments. As such, it is simply not a case of trading futures because swaps are too expensive.
  3. Futures pricing in the roll can highly variable, and the cost of funding in subsequent rolls is unknown today.

One way around this dilemma is to pursue a fully funded alternative. This might be an ETF whose management fees and tracking error are low compared to the currently high funding rates in swaps and futures. However, this requires access to cash equal to the desired notional exposure.

Options structures

Another way to access beta is through options. Unlike futures and swaps, current option pricing works in favour of those looking to go long. This is due to significant increases in skew over the past year, which has made the price of downside put options more expensive relative to upside call options. This offers cheap entry points for beta-like strategies.

For example, in S&P 500 it is currently near zero-cost to sell a 3-month 90% put option and buy a 3-month 104% call option – a combination known as a risk-reversal. This provides a buffer on the downside of 10%, but only a 4% hurdle on the upside until the option becomes in-the-money. This asymmetry is appealing for those looking for cheap upside exposure. This chart shows the scenario analysis of this strategy at trade date and at maturity.

When looking at gaining the most efficient exposure to equities, it is important to consider all the alternatives and weigh the pros and cons of each. At the moment, the overall cost of funding has increased pricing on total return swaps and futures but at the same time, the option market dynamics have made it historically inexpensive to use options to get equity exposure. In a lower expected return world, finding free outperformance through efficient implementation can provide a little bit of extra return for the overall portfolio.