Asset allocation and index futures during market crises

Blog post
Shuo Xu, Wei Xu, Zhen Wei
March 25, 2020
  • Derivatives contracts like futures and options are often employed by institutional investors to hedge against market risks or express views on certain performance/risk characteristics.
  • Increased levels of liquidity in futures based on the MSCI EM and MSCI China Indexes during recent years have allowed some market participants to augment asset-allocation policies based on these "integrated" multicurrency futures contracts.
  • The percentage increase in trading activities in futures based on the MSCI EM Index was higher than in the EM equity cash market during recent market crises.
During past market crises, institutional investors have employed derivatives contracts like futures and options to hedge against market risks or express views on certain performance/risk characteristics.
Asymmetric beta of EM equities
The global equities market, as measured by the MSCI ACWI Index, returned -26.4% during Jan. 31, 2020, through March 16, 2020, marking the biggest market drawdown since the 2008 global financial crisis (GFC). By comparison, the MSCI Emerging Markets Index outperformed the broader market by 5.0% during the same study period. Over a long-term sample period from December 1987 through February 2020, however, emerging-market (EM) equities more often underperformed when broad equity markets declined. Further, the EM drawdowns have historically been larger than those in developed markets (DM) during market crises. Why? One reason is that EM equities have historically been a "high beta" asset class, and its beta during market downturns (1.4) has been higher than during market upturns (1.1). Emerging-market beta has moved as high as 1.9 during prior global market crises when the MSCI ACWI Index declined by more than 8% in one month.
Emerging markets historically more susceptible to downside than upside risks
Note: "Beta – Up", "Beta – Down" and "Beta – Tail Risk" denote the regression slope of monthly returns of the MSCI EM Index versus monthly returns of the MSCI ACWI Index conditioning on the monthly returns of the MSCI ACWI Index were positive, negative and below -8%, respectively ("Tail Risk"). Calculation is based on index data from December 1987 to February 2020.
This "asymmetric beta" feature of the EM equity asset class was due, in part, to the procyclical nature of the EM currencies (that is, positively correlated to the economy) and EM economies' higher vulnerability to external shocks.1 As a result, managing EM equity exposure effectively during such challenging times has become a critical issue for global investors and asset allocators.
Asset allocation with index futures based on MSCI EM and China Indexes
With market volatility rising to the highest level since the 2008 global financial crisis during recent weeks, some investors' asset-allocation policies may trigger a total portfolio rebalancing and exposure adjustment. In addition, some investors may choose to implement tactical asset allocation (TAA) in an attempt to capture medium-term (three- to 12-month) opportunities within asset classes or market segments. For instance, as the COVID-19 pandemic unfolded, we saw initial underperformance and subsequent outperformance of the Chinese equity markets, leading to what some saw as a window of potential TAA opportunities.2 There are many approaches to implement exposure management or tactical asset allocation in investors' EM/China equity allocations. Among them, three types of strategies were more commonly practiced in the past:3 (1) direct transaction or over-the-counter (OTC) swaps in the cash and currency markets; (2) baskets of locally traded futures and transactions in currency markets; (3) integrated futures contracts such as the MSCI EM and MSCI China Index futures.
Three approaches in managing EM and China exposures during previous crises
Approach
Cash/OTC market
Basket of local futures
Integrated futures
Approach

Why it may have been chosen

Cash/OTC market

Provided direct way to adjust portfolio holdings Allowed for highly customized, high precision in exposure management Have handled both systematic and idiosyncratic risk exposures

Basket of local futures

Provided flexibility in accessing various liquidity avenues Proved cost-efficient May have avoided exacerbating potential cash/currency-market distress

Integrated futures

Allowed for absolute alignment in targeted exposure Provided operational efficiency in handling multilocation and multicurrency trades May have avoided exacerbating potential cash/currency-market distress

Approach

Why it may not have been chosen

Cash/OTC market

Transaction costs historically rose during market crisis, and there was potential for double-layer fees Potential liquidity issues in cash and currency markets arose It was operationally challenging to deal with different time-zone settlement cycles and exchange rules Potential for collateral damage and contagion risk arose when active portfolios rebalanced in scale Potential counterparty risk arose for OTC transactions

Basket of local futures

Required additional currency overlay/ exposure management Potential liquidity issues in currency markets arose It was operationally challenging to deal with different time-zone settlement cycles and exchange rules Tracking error to the actual exposure was sometimes high

Integrated futures

Were readily available There was a potential lack of liquidity and ecosystem at early stage of contract initiation Did not always allow for precision, especially when investors wanted to adjust specific exposures to certain local markets

MSCI EM Index futures-trading activities during past crises
In our previous post, we documented increasing liquidity and open interest of futures based on the MSCI EM Index over the past few years. Moreover, we find that investors have made more use of these integrated futures contracts during market crises. In the exhibit below, we examine four main periods of market crisis since 2011, contrasting the EM cash market with the EM futures market in their patterns of trading-volume growth. In general, we observed a significant rise of trading volume in both cash and futures markets during the studied crisis periods. Furthermore, the trading-volume increase in the futures market was much more significant than in the cash market, suggesting investors may have more heavily participated in the futures market during turbulent times.
Market crises versus normal times: Cash and futures market-volume changes
Crisis event
Event date
Cash market volume change
Futures market volume changes
Crisis event

U.S. debt

Event date

8/8/2011

Cash market volume change

+40%

Futures market volume changes

+71%

Crisis event

China currency

Event date

8/24/2015

Cash market volume change

+31%

Futures market volume changes

+79%

Crisis event

"Volmageddon"

Event date

2/5/2018

Cash market volume change

+41%

Futures market volume changes

+89%

Crisis event

COVID-19

Event date

3/6/2020

Cash market volume change

+70%

Futures market volume changes

+156%

Source: Thomson Reuters, MSCI. Notes to the calculation methodology: 1. Cash market volume is based on the market-value-weighted turnover of MSCI EM Index constituents, and futures-market volume is based on the trading volume of E-mini MSCI EM index future. 2. Change (in %) is defined as the turnover or the volume during the event period to divide by that during normal period minus 1. Event period is +/- 5 business days to the event date. Normal period is +/- 3 months to the event date (excluding the event period). 3. Turnover is defined as the daily traded volume to divide by the floating number of shares and is averaged by MV weight. 4. The second week of the last month in each quarter for rolling futures trading is excluded when calculating the futures volume of a normal period.
Specifically, the weighted average turnover of the constituent stocks in the MSCI EM Index rose approximately 30% to 70% during our studied market-crisis periods compared with normal trading days. On the other hand, the daily trading volume of the E-mini future based on the MSCI EM Index contract experienced sharper increases of 70% to 160% during market crises, compared with normal trading days. Implementing crisis-period exposure management and TAA policies through integrated futures may be an option as investors seek to manage through increased market volatility.
Further Reading
Coronavirus and financial markets Emerging Markets since China A shares' inclusion China and the future of equity allocations Looking to the futures of emerging markets Using multi-country multi-currency futures in portfolio management
Shuo Xu
Shuo Xu
Executive Director, MSCI Research
Wei Xu
Wei Xu
Executive Director, MSCI Research
Zhen Wei
Zhen Wei
Managing Director, MSCI Research

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1A global market crisis more often contributed to increased level of market frictions in EM as well as potential liquidity risks in their cash equity and currency markets. For example, more than 20% of the three worst months of the MSCI EM Index’s performance on average was contributed by the decline of EM currencies versus the U.S. dollar during financial market crises. For example, see:
Hawkins, J. and Klau, M. 2000. “Measuring potential vulnerabilities in emerging market economies.” BIS Working Papers.
Chiṭu, L. and Quint, D. 2018. “Emerging market vulnerabilities – a comparison with previous crises.” ECB Economic Bulletin.2China’s equity market underperformed other EM and global markets during the first phase of the outbreak when the impact was largely within China. With COVID-19 going global and China’s domestic outbreak more under control, China started to outperform other markets since Feb. 4, 2020. Similar market-cycle dyssynchronization was observed during the 2008 global financial crisis.3See: Fabozzi, F. and Markowitz, H. 2011. , John Wiley & Sons.

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