How Do Etfs Work In Risk Management Applications

Existing ETFs are all based on benchmark indices. While there are important benchmarks and there are unimportant benchmarks, benchmark index derivatives are widely used in risk management applications. For example, an investor with an actively managed small-cap portfolio might feel that superior stock selection reflected in the portfolio will provide good, relative returns over the period ahead, but that most small-cap stocks might still perform poorly. The investor can hedge the portfolio's exposure to small-caps while capturing its stock selection advantage by hedging the small-cap risk with a short position in a financial instrument linked to the Russell 2000 small-cap benchmark index. Available risk management tools for this application range from futures contracts and equity swap agreements—to the shares of a small-cap exchange-traded fund.

Derivative contracts have limited lives. Equity index futures contracts will usually be rolled over about four times a year in longer-term risk management applications. While risk managers could take futures positions with more distant settlements, liquidity is usually concentrated in the nearest contracts. Consequently, risk managers typically use the near or next contract and roll the position forward as it approaches expiration. Similar expiration provisions apply to most swap agreements, leaving the typical derivative transaction with considerable "roll" risk—risk of adverse market impact from rolling the hedge forward to the next expiration.

If a hedger uses ETF shares instead of futures, a risk management position can be held indefinitely without roll risk. Of course, the open-end nature of an ETF risk management or hedging position has other differences from futures and swaps. There is an implied cost associated with the expenses of the fund that may make the ETF a better short hedge, and there may be tracking error between the ETF portfolio and the benchmark index, but these are usually small considerations relative to fluctuating roll risk and recurring transaction costs in a longer-term rolling derivatives hedge.

Exhibit 4.1 illustrates two snapshot cost analyses of long stock index futures versus long ETF shares as one-year portfolio replication positions. When these analyses were prepared (at different times), they

EXHIBIT 4.1 Comparisons of Long Position Costs in iShares S&P 500 Fund and S&P 500 Futures for One-Year Portfolio Replication Applications (All numbers in basis points (bps) unless otherwise indicated)

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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