An Improving Environment for Capital-Efficient Equity Investing

An Improving Environment for Capital-Efficient Equity Investing

Equity index futures are among the most liquid and cost-effective ways for investment managers to capture the returns of major stock market indexes such as the S&P 500 and Russell 2000 – especially now that financing costs have cheapened.

Futures allow investment managers to use capital more efficiently. They facilitate full exposure to a given market beta (market index return) for a minimal financing cost (roughly Libor) while freeing up the bulk of capital to pursue alpha (returns in excess of the market index).

Financing costs in the equity futures market may remain favorable in the environment described in our latest Cyclical Outlook, “Growing, But Slowing,” which points to higher volatility and lower market returns as the business cycle matures and central banks dial back their post-crisis monetary support.

Supply and demand

The financing cost of equity futures is primarily determined by supply and demand. In normal market environments, investors can expect to finance equity index exposure at roughly short-term rates, such as Libor (the London Interbank Offered Rate).

However, in late 2017 and early 2018 financing costs increased sharply as the persistently strong returns of the S&P 500 coupled with low volatility spurred demand for long equity exposure (more buyers) and reduced the demand for hedging (fewer sellers). Meanwhile, post-financial-crisis regulatory changes have reduced the ability of banks to commit capital to the equity futures market (less supply).

As a result, S&P 500 futures saw their richest roll (the implied financing rate) in nearly 10 years at 73 basis points (bps) above Libor, and Russell 2000 futures spiked to 41 bps above Libor – the first time Russell 2000 futures rolled at a premium to Libor in the last 15 years (see chart).

Financing costs have normalized

Financing costs have normalized

Yet markets can remain one-sided for only so long.  

When volatility picked up and markets corrected in February of 2018, speculative long investors trimmed exposure and increased hedges, causing financing costs to decline toward longer-term averages. Consistent with what we have observed historically, the spike in financing costs was transient and conditions have normalized. S&P 500 futures rolled at roughly Libor and Russell 2000 futures rolled at Libor -12 bps, according to Bank of America Merrill Lynch data as of 30 June 2018.

More attractive conditions may lie ahead

Going forward, we expect the financing market for equity futures to be favorable.  With higher market volatility and elevated equity valuations, demand for long and short equity exposure should be more balanced, decreasing upward pressure on financing costs. In addition, recent trends toward relaxing bank regulation will likely ease funding pressures over the medium term.

(Of course, it is important for investors to monitor the evolution away from Libor as described in “So Long, Libor: Transition Is Underway to SOFR and Other Alternative Reference Rates.”)

We believe capital-efficient strategies that incorporate equity futures may be valuable in the low-return environment ahead.

For more of our views on investing in a late-cycle environment, please read our Cyclical Outlook, “Growing, But Slowing.”

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Laura Graff is an equity strategist in PIMCO’s Newport Beach office.

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All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.