With strong growth in the tech sector, everyone’s talking about the FAANG stocks (Meta Platforms’ Facebook, Amazon, Apple, Netflix and Alphabet’s Google). These stocks are actively traded and widely followed. Another widely followed growth stock, Tesla, has entered the arena with significant gains in the last several years.
The MICRO NYSE FANG+™ Index Futures contract (MICRO FANG+™) provides a way to trade an Index based on the FAANG stocks and five other leading tech/growth issues, including Tesla. The futures contract is actively traded on ICE Futures U.S. Since the contract size is considerably smaller than most other stock index futures, it allows for greater flexibility, cost efficiency and accessibility for a wide range of participants.
The NYSE FANG+™ Index (“NYFANG” or the “Index”) has displayed an overall total return greater than 450% for the period 1/3/2017 through 10/29/2021. This year alone, the Index has gained over 22% on a gross total return basis. Its performance is even more impressive given that only two of the NYSE FANG+™ Index stocks pay dividends.
Looking at performance since the market bottomed in March 2020, the NYSE FANG+™ Index has outperformed the overall market as measured by the S&P 500®. The sharp rise in Tesla Inc. (TSLA) has been one of the key drivers in the Index’s performance - see the table below.
An investor holding a portfolio of growth stocks including TSLA that correlates closely with the NYSE FANG+™ Index might be concerned that a pullback is overdue and may be looking for ways to protect against a short-term downside move. Obviously, selling all or part of the portfolio including TSLA is always an option. However, transaction costs and tax implications -- (short term or long-term capital gains) -- need to be considered. Another approach may be to use MICRO FANG+™ futures as a hedge to provide downside protection.
What is Hedging?
Hedging is a strategy employed to offset losses in one asset by taking an opposite position in a similar or related asset. Futures contracts are an ideal choice for hedging in many asset classes, including commodities and securities. In simplest terms, a futures contract allows an investor to buy or sell a specific asset at a predetermined time and price. As discussed below, an investor looking to protect an investment can simply buy or sell a futures contract to help protect the asset against losses for a specified period of time.
The Simple Hedge
Assume an investor is holding a portfolio consisting of the FAANG stocks, including TSLA, and other growth issues. Further, it is determined that the portfolio correlates very highly with the NYSE FANG+™ Index. Again, the investor is concerned with the extent that TSLA, as well as his overall portfolio, has sharply outpaced the market. To obtain downside protection against a pullback in his portfolio, the investor wishes to use MICRO FANG+™ futures as a hedging vehicle. The current value of the portfolio is $100,000 and the value of a MICRO FANG+™ futures contract is $37,500 ($5 x 7,500). As a simple hedge, the investor could simply sell an equal notional value of MICRO FANG+™ futures vs. the notional value of the portfolio. In this case, 3 MICRO FANG+™ futures would be sold (100,000 / 37,500) = 2.7. Below is an example of the results of this hedge assuming a 5% move in both the portfolio and MICRO FANG+™ futures.
|Portfolio Value Gain/Loss||MICRO FANG+™ Gain/Loss||Net Gain/Loss|
Several key points are important when regarding this simple example:
The Beta Hedge Example
Beta is a statistical measure of an individual stock or portfolio’s volatility relative to the overall market or a specific market index - in this case the NYSE FANG+™ Index. Beta is used in the capital asset pricing model (CAPM). This model has been widely used for decades as a measure of the volatility of a security or portfolio relative to the overall market or a specific index.
A positive beta indicates that a stock or a portfolio moves in the same direction as the market or index. A beta of 1.0 indicates that historical price movements in the stock or portfolio have perfectly matched those in the index. A beta greater than 1 indicates that the performance of the stock or portfolio has been more volatile than the index. For example, a beta of 1.2 indicates that over time the value can be expected to change 120% more than the underlying index. Technology and small cap stocks often have betas greater than 1.00 relative to the overall market. A beta lower than 1 indicates that the performance of the stock or portfolio has been less volatile than the index.
It should also be noted that some stocks and industry groups can at times have negative betas. This reflects the fact that there is an inverse correlation with the market. Gold stocks are often cited as an example of stocks that will decline (advance) when the market advances (declines).
Given that beta provides a statistical representation of a stock or portfolio’s relative volatility, it is often used by investors and portfolio managers to develop an appropriate hedging strategy for correlated index products. Specifically, an investor looking to hedge a stock portfolio with MICRO FANG+™ futures would determine the proper hedge ratio by dividing the portfolio value by the MICRO FANG+™ contract value and multiplying by the beta of the portfolio relative to the NYSE FANG+™ Index.
(Portfolio $ Value / MICRO FANG+™ $ Value) x Beta = Hedge Ratio
As an example, consider an investor holding a portfolio of the following Index stocks.
Given the sharp run-up in the market since last year, the investor is concerned about a near term pullback of his holdings. He is especially concerned about TSLA which has significantly outpaced the other stocks. He views any decline as short term and does not want to liquidate some or all of his holdings. He looks to use MICRO FANG+™ futures as the appropriate hedging vehicle for his position and determines the appropriate beta for the portfolio vs. the Index is 1.5. The hedge ratio is calculated as 5.25.
($133,600 / $37,500) x 1.5 = 5.34
The beta of 1.5 indicates that the portfolio on average will have a 150% greater move than the underlying Index. By selling 5.34 MICRO FANG+™ contracts, the volatility of the portfolio is considered when determining the hedge.
To illustrate, the following provides a hedge example assuming that the Index drops 10% and the portfolio drops 15% as expected.
|NYSE FANG+™ Index||7,500|
|$ Notional Value - 5 contracts||$187,500|
|Gain from short 5 futures1||$18,750|
1 $750 x $5 multiplier x 5 contracts
2 Assumes the portfolio value declines in line with the 1.5 beta
It’s important to note that the beta (hedge ratio) will likely not remain static over the course of the hedge. It is based on historical data and provides a representation of the relative volatility between the portfolio and the Index at that point in time. In addition, note that the beta of the stocks and portfolio can vary depending on the timeframe one uses to determine the calculation (i.e., 1-year beta, 3-year beta, etc.). The hedge needs to be closely evaluated over time and of course the hedging coverage can be reduced or expanded by buying/selling MICRO FANG+™ futures.
The above examples demonstrate how one can utilize MICRO NYSE FANG+™ futures as a simple hedge and use the widely used metric called beta to manage risk for equity portfolios. While a futures hedge that is properly established can help insulate an investor from losses, futures trading is not for everyone. Investors should have knowledge of how futures contracts and markets operate, and how to calculate the relative beta value between a portfolio of individual stocks and the MICRO NYSE FANG+™ futures contract before engaging in such risk management strategies. In addition, it’s important to keep in mind the following:
Given these factors, a beta hedge needs to be closely monitored and needs to be based on how much market risk the investor is willing to accept.
This article is provided for informational and educational purposes only. This article may include observations made by Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or any of their affiliates of general market movements and trends, but nothing herein is intended to be a solicitation or a recommendation to buy, sell or hold securities or futures contracts. Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or their s affiliates do not provide legal, tax, accounting, investment or other professional advice. Clients should consult with an attorney, tax, or accounting professional regarding any specific legal, tax, or accounting situation. The article described general investment strategies, which do not take into account any of the specific needs or financial circumstances of any person, entity or group of persons and should not be considered investment advice. All information provided by Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or their affiliates, including without limitation, any materials that describe any Index, is of general nature only.
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