How banks replicate index exposures
Delta-one trading has been an area of significant growth and investment among financial services firms for the better part of the last decade. The expansion of the business has been such that, within the equities division of many investment banks, the delta-one trading desk interacts with a broader range of clients—from pension funds, insurance companies and endowments to family offices, sovereign wealth and hedge funds—than any other single trading group.
Given the focus on this business and the scope of its interaction with clients, there remains a surprising lack of clarity among many industry participants as to what the delta-one desk actually does.
The reason for this is, in large part, linguistic. A “delta-one” product, in financial services parlance, is one that provides the investor with economic exposure to an underlying reference asset without actual ownership of the asset. The term comes from the language of risk analysis, where “delta” is the measurement of the sensitivity of a derivative to movements in the price of the underlying asset class or security. Options contracts, for example, have a delta between 0 and 1, which varies over time and depends on a number of factors (market level, volatility, etc). Delta-one products, by contrast, have a constant unit delta, providing the investor with one-for-one exposure to the underlying asset.
The confusion arises from the fact that most trading desks describe themselves by the product in which they execute trades (e.g. “cash equities”, “convertible bonds”), while the delta-one desk describes itself by the type of exposure it provides. The specific product used to deliver this exposure depends on the requirements of the client and includes total return swaps, ETFs, futures, forwards, certificates, and combinations of warrants and options.
Adding to the complexity is the fact that the range of underliers to which clients obtain exposure via delta-one products is exceptionally broad and includes not only single stocks, equity indices and custom groupings (“baskets”) of stocks, but, through the rapid evolution of ETFs and other exchange-traded products, also fixed income, currencies and commodities.
In light of the exceptional breadth of reference assets and delivery mechanisms, the fact that the delta-one desk has such a wide-reaching interaction with the client base is unsurprising; very many clients can, in one way or another, benefit from a “synthetic” exposure to an underlier, rather than direct ownership.
It also helps to explain why so many investors are unclear on what “delta-one” means. Very few clients would have interaction with all areas of a delta-one desk and therefore tend to think in product terms. In their own mind they trade with the “ETF desk” or the “swaps desk” while, from a trading perspective, these are different approaches to the same problem and therefore risk managed by the same group of people—the delta-one trading desk.
In this article we will look at the origins and evolution of the delta-one trading business. As a thorough overview of the activities of a mature delta-one desk is beyond the scope of the article, we will focus on a particular business area: the replication of index exposures. Index products make up a significant portion of the delta-one business. A review of the development of these products provides useful insight into the interaction between investor demands, product innovation and sell-side development and how these competing interests have led to the structure of the modern delta-one trading desk.
Within the range of products traded by delta-one desks, equity index products provide a particularly clear example of why an investor would purchase an asset that provided economic exposure to an underlier as opposed to purchasing the underlier directly. The reason for this is quite simply that indices are themselves not tradeable products. An equity index is ultimately a number, whose value represents the weighted average price of a portfolio of securities. When an investor wishes to gain exposure to an index he/she must either:
- Purchase all of the underlying securities of the index in their respective weights and keep the composition up to date as weights change due to corporate actions, rebalances, etc.
- Purchase a product that replicates the index performance.