Welcome to Futures Industry
Will Acworth
Published 5/1/2002

Diane Garnick is an expert on using derivatives to outperform the market. During the heydays of the 1990s, she was director of equity derivatives strategy at Merrill Lynch and several times won recognition from Institutional Investor as the top analyst in her category. A year ago she switched to the buy side and became global investment strategist at State Street Global Advisors, where she helps advise institutional clients on the use of derivatives. In an interview with Futures Industry, she talks about the use of equity indices, the cost of the futures rolls, and building an analytical framework to identify and capture mispricings in the market.

One of Garnick’s central insights is that the long bull market in U.S. equities conditioned institutional investors to behave in certain ways, and those behavioral patterns continue into the present even though the bull market has come to an end.

The key concept here is “anchoring”—an individual’s point of view is “anchored” in the range of experiences that he or she has undergone. As a simple example, think of how people’s reaction to a snowstorm might differ. A person who grew up in Chicago would interpret eight inches of snow as a big snowfall, whereas a person from New York would have the same reaction to just four inches of snow.

Turning to the futures markets, Garnick says it’s easy to see that a majority of the current traders and investors have grown up in a bull market for equities. Keep in mind that careers in the futures business, as in professional sports, tend to have relatively short life spans, which means that the typical trader is only now encountering the type of market conditions associated with a bear market for equities.

So how does this affect investment behavior? During a bull market, investors are typically influenced by factors like greed, peer pressure and the fear of underperformance. “During bull markets, the desire to fully participate in the market through buying futures outweighs pricing considerations,” says Garnick. “Hence, we see strong long-sided demand for futures from institutional investors who want to be fully equitized.”

Contrast this behavior with what usually occurs in a bear market, when the investor’s mindset is characterized by fear, hesitation and risk aversion. “Bear markets, like the one that we’re experiencing now, demand that investors focus on risk management and costs,” Garnick adds. “Consequently, short-sided futures demand materializes, reducing the cost of rolling futures contracts forward to the next expiry.”

Growing Up in a Bull Market

Let’s take a look back for a moment to see just how exceptional the last 30 years have been in terms of the U.S. economy. Since 1973, which happens to roughly coincide with the use by market participants of the Black-Scholes model for pricing options, the U.S. economy has been in an expansionary mode 86 percent of the time. The average expansion lasted for more than five years, while the average recession lasted less than one year.

Looking at the more recent data, the last trough measured by the National Bureau of Economic Research in the U.S. economy was in March 1991. From then on, the economy was in expansionary mode for exactly 10 years, all the way up to March 2001, and U.S. stocks had a remarkably long run. In fact, this most recent bull market was around for almost 10 years, making it the longest running bull market in U.S. history.

What this means is that the current generation of derivatives users is accustomed to a relatively stable uptrend in the business cycle and has had limited experience with high volatility until quite recently.

How does Garnick apply this insight? One place where she sees the effect of this long exposure to bull market conditions is in the cost of rolling positions in the S&P 500 futures contract. Remember that the S&P 500 is one of the main benchmarks for measuring the performance in the institutional world, and using S&P 500 futures is a very efficient and popular way to equitize cash flows.

Garnick argues that during the bull market, portfolio managers became used to a relatively expensive roll, and they were willing to pay for this to eliminate what they viewed as a higher cost, namely the cost of not being fully invested. To illustrate this point, Garnick points to data on the S&P calendar spread, which shows that all through the second half of the decade, roll costs were relatively high compared to the cost of carry. In fact, the last time the S&P 500 futures roll traded below fair value was in September 1998, right around the time of the Asian crisis and the LTCM debacle (see Figure 1).

An interesting sidelight on the use of derivatives in the 1990s is that stock options became a favored way to boost employee compensation, particularly in the upper income brackets, because of the pervasive demand for equity exposure. According to the Bureau of Labor Statistics, options accounted for 26.8 percent of total compensation for people making $75,000 per year or more, and 10.2 percent of total compensation for people making $50,000 to $75,000 per year.

“In a recessionary environment, I believe this creates what economists call an automatic downward stabilizer,” Garnick says. “In other words, compensation costs fall as the value of the options goes down, and this allows employers to reduce employee compensation expense without having to renegotiate contracts.”

Strike That; Reverse It

Conditions have changed dramatically since the bull market. First, the focus of investors has shifted from systematic risk to specific stock selection, and from participation to pricing. Second, economic instability has helped raise volatility levels. And third, because derivatives users have a bias toward bull markets, there are opportunities to capture bear market anomalies.

Let’s look again at the cost of the S&P 500 roll. “The two things we need for a cheap roll to occur are overall bearish sentiment and low volatility, and right now we have both,” she observes.

“Volatility, for instance, has come in very dramatically since the beginning of the year. The cost of the roll is still a lot higher than it should be, but it is coming down, and this is making the S&P 500 futures contracts more attractive to certain portfolio managers.”

For example, ever since the American Stock Exchange introduced exchange-traded funds, some portfolio managers have used these products as an alternate mechanism for getting broad exposure to the equity market. ETFs have no roll costs, but compared to futures the spread is wider and the commissions are higher. She argues, therefore, that a low cost roll is the number one factor that makes ETFs prohibitively expensive versus S&P 500 future.

Another sign of the bear market is in the puts-to-calls ratio on the S&P 500 (see Figure 2). Garnick’s view is that whenever delta-adjusted S&P 500 put open interest exceeds call open interest one week prior to expiry, there tends to be a positive bias in the cash market during expiry week. This happens because if investors are long puts, brokers will be short puts, and the brokers will hedge by shorting the futures. And when they buy back all the futures during expiry week, this creates upward pressure on the underlying market.

“If you look at the data points from 2000 and 2001, which is after the tech stocks started to correct, you can see this effect, and what it means is that the derivatives markets are finally impacting the cash markets,” she says. “It’s a sign that the derivatives markets are finally growing up.”

(In case anyone is wondering, she adjusts data to normalize the strike prices for all the puts and calls, so that it reflects the degree to which the imbalance will generate hedging activity by the brokers.)

Innocence Breeds Opportunity: Bear Market Anomalies

During bear markets, investors become very concerned with maintaining capital, but they still want to maintain participation in equity. So in this type of environment a common structure is to combine a minimum yield through the use of fixed income instruments with limited participation in equity upside. In other words, you sacrifice some of the potential upside in return for a guaranteed floor on the overall return. These products in turn create more demand for futures and options—in effect you are buying S&P calls for the equity upside, and buying eurodollar futures to hedge the downside.

During the bull market, there was a lot of turnover in the components of the S&P 500 because the hot new companies like AOL and Yahoo had to be included. With the bursting of the internet bubble and the general slowdown of the economy, the turnover has slowed way down, and the index is a lot more stable from a volatility perspective. This is lowering the volatility of options and reducing the long-side demand in futures.

Another anomaly is that stocks tend to be neglected during bear markets, in part because so many Wall Street analysts are laid off. During these times, identifying stocks that are undervalued by the market becomes a lot easier and value stocks tend to outperform the rest of the market, as one can see by charting the monthly returns of the Barra Growth and Value indices.

Call overwriting is another example of an area where Garnick sees opportunity. Many investors are hesitating, believing that volatility will pick up again in the short term. But if volatility continues its downward decline, then call overwriting could make a lot of sense.

“Most volatility investors have only been in the market for a short period of time, which creates a lack of historical perspective,” Garnick says. “Volatility seems low if we look back over the last five years, but over the very long run, volatility is still somewhat high. Hence, volatility investors should consider the mean reverting nature of volatility and expand their horizons beyond the most recent decade.”

FIGURE 1: S&P 500 Calendar Spread
Implied cost of carry versus forward rate using gross dividend point

Source: State Street Global Advisors

FIGURE 2: SPX Delta Adjusted
Open Interest Differential and Expiration Week Return

Source: Merrill Lynch

Will Acworth is the editor of Futures Industry magazine.
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