LEVERAGE
Many investors and traders don’t fully understand the concept of leverage; therefore, it scares everyone. More and more people tell me that they understand how leverage works—they realize that futures give you the type of leverage that no other financial vehicle gives you—yet these are the same people who will go out and buy an index fund paying 100 percent margin rather than establishing a futures position, which creates synthetic exposure and gives the investor much more leverage and flexibility. That fact proves to me that people talk about leverage but don’t really understand how to use it.
Perhaps the best example of institutional use of leverage in the marketplace is found in the world of index arbitrageurs. Index arbitrage is a strategy that takes advantage of the disparity between the futures price and the underlying cash price of a given index. Whether you’re doing an S&P arb, a Nasdaq arb, a Russell arb, or a GSCI arb, the actions and mechanics of the trade are identical; it’s the execution of the underlying products that differs. All index arbitrage is basically the same in structure. The only difference is when the arb is executed with a commodity-based index rather than using equities as an underlying market. Either way, the trader is taking advantage of the aberrations based on what you would consider to be a fair value between the futures contracts and the underlying index.
Most arbs are successful because they are able to use the 20-to-1 leverage that futures inherently give them. Without the incredible amount of leverage that’s available to these trading desks, they would not be able to put on the enormouse multi-billion-dollar positions that drive the market up or down, especially during expiration and at times when the indexes are being rebalanced.
Leverage also gives the hedge funds the ability to enhance the yield on a given product. This is evidenced by the many index funds being marketed at present that use a synthetic futures position to replicate equity exposure and sell covered calls and credit spreads overlaying the core position. Many of these funds give investors what they consider to be a two- or a three-beta fund, which, in layman’s terms, gives investors double or triple the amount of leverage they would normally get through a conventional investment. The most critical element in dealing with leverage as a concept is managing the risk created by the trade.
HEDGING
True hedgers are a completely different breed than the other players in the capital markets universe. Old-time hedgers were exactly what you would expect them to be: farmers, a cattle ranchers, people looking to lock in the future price of their underlying crop or herd. But now hedging has evolved into a strategy that is much more sophisticated than ever in the history of commodity trading. At present, the large hedges that we see moving the market are fund managers who are looking to cover exposure in an entire portfolio without having to upset the balance of that portfolio. It becomes much more effective and efficient for a portfolio manager with a sizable portfolio to sell futures instead of the underlying cash position in the event of expected market weakness. An example is a portfolio manager at Fidelity or Putnam who would use a short position in the stock index contracts to hedge out any downside exposure to the portfolio without having to sell out individual issues of stock. There are swap traders and forward rate agreement (FRA) traders who hedge out every transaction, turning fixed-rate products for variable-rate products or vice versa, by using the eurodollar futures or options, which have turned what was a small, niche fixed-income contract into the world’s largest and most liquid.
Those swap trades—specifically, the flow that comes off of the swap desks of the major money center banks and institutions around the world— have created the largest spreaders marketplace in the world. That’s not to say that we still don’t see the old-time hedgers using futures for their intended purpose in the agricultural markets.
Some of the old-time houses such as Cargill and Archer Daniels Midland (ADM) are still in the marketplace using the contracts the way they’ve used them for the past 100-plus years. The questions are, at what point does hedging out the risk make sense, and at what point does the cost of the hedge become an obstacle to profitability? A strategy called dynamic hedging was employed during the 1987 stock market crash, which was a trade that sold index futures, regardless of fair value, to cover exposure in a breaking market. The hedging technique that was being incorporated became a self-fulfilling prophecy for a market that was already in a weakened state.
Unfortunately, the strategy added incredible amounts of selling pressure, which helped to break the market. There are many reasons why that happened, most of which have been fixed through a strong cooperative agreement among the exchanges in Chicago and the equity exchanges in New York, with the Federal Reserve acting as ultimate vanguard. But the most important lesson learned from this experience is that at times hedging simply doesn’t work. It took a stock market crash for institutions that were new to futures to learn what farmers and ranchers have known forever— that hedging is an art form like no other!
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