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academic assessment of the very existence of index-based derivatives and the implications of the still-growing popularity of these complex risk mitigation, arbitrage and speculation instruments are both in short supply. Figure 4 Options Traded On Global Organized Exchanges Year-End Notional Principal Analysis And Interpretation According to the Bank for International Settlements, the notional value of global derivatives traded over-the-counter (OTC) as of December 2011 was nearly $648 trillion, with gross market values of over $27 trillion. The notional value of derivative instruments traded on organized exchanges as of December 2011 reached almost $56.5 trillion, with equity index-based derivatives reaching roughly $3 trillion (Bank for International Settlements 2012). See Figures 2-4. Figure 1 Derivatives Market Volume Billions Of USD $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 Source: Bank for International Settlements Figure 5 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 ■ Interest Rate ■ Currency ■ Equity Index Global Equity Market Capitalization 2005 2006 2007 2008 2009 2010 2011 Billions Of USD $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ■ OTC ■ Exchanges ■ Global Equity Market Source: World Federation of Exchanges and Bureau of International Settlements Figure 2 Billions Of USD Over-The-Counter (OTC) Derivatives: Total Contracts Year-End Notional Amounts Oustanding by Category $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 ■ Foreign Exchange Contracts ■ Interest Rate Contracts ■ Unallocated ■ Equity-linked Contracts ■ Commodity Contracts ■ Credit Default Swaps Source: Bank for International Settlements Figure 3 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 Billions Of USD 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Futures Traded On Global Organized Exchanges Year-End Notional Principal 1986 1987 1988 1989 1990 Source: Bank for International Settlements ■ Interest Rate ■ Currency ■ Equity Index 2011 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Millions Of USD $70,000,000 $60,000,000 $50,000,000 $40,000,000 $30,000,000 $20,000,000 $10,000,000 $0 Source: World Federation of Exchanges 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 In comparison, the World Federation of Exchanges calculates the global market capitalization of all equity markets at just under $47.5 trillion (World Federation of Exchanges 2012). Despite the upward trend in global equity market capitalization (see Figure 5), this number is dwarfed by the dollars traded in derivatives on exchanges, let alone OTC. Certainly, the attractiveness and widespread use of index-based derivatives is ubiquitous across markets. Moreover, as displayed in Figures 2-4, the growth of both OTC and exchange-traded derivatives, which include an abundance of index-based vehicles, has been more than significant in recent years. The towering derivatives market is a commentary on our mindset as investors and on our constant need to manipulate the market portfolio in our favor. Achieving more upside and less downside is our historic struggle, and the outsized derivatives market is evidence of the lengths we will go to in our quest for alpha. The introduction of index-based derivatives is seen by many as the most important financial market advancement in modern times. Banks, pension funds, insurance companies, mutual funds, exchange-traded funds, separately managed accounts, hedge funds and government holdings all partly consist of index-based derivatives. Their presence has become common practice to most institutional investors and even many retail investors. “In fact, index-based contracts have become such an indispensable feature of the global financial system that it would be safe to say that there are many millions in the West continued on page 41 November / December 2012 37
Profiles In Pensions IMRF’s Shah Stays The Course New CIO not anticipating any big changes The Journal of Indexes sat down with Dhvani Shah, who became the CIO of the Illinois Municipal Retirement Fund last December, to talk about her fund’s allocations and how it uses index strategies, among other topics. IMRF is the 51st-largest pension system in the United States and the second-largest (and one of the best-funded) public pension system in the state of Illinois. Illinois Municipal Retirement Fund Assets: $26.1 billion Funding: 80.2% Passive/Active Mix: 25.7% / 74.3% JOI: How does your team approach the investment process? Shah: We have an annual review of our investment policy statement, real estate policy statement and strategic asset allocation. That’s an opportunity to fine-tune things as needed. We also conduct an asset liability study about every three years. Actually, the next one is scheduled for next year, 2013. Within our public market portfolio, we have active managers, as well as index investments. For example, within domestic equity, we have about $3.5 billion in index investments, which is about 43 percent of the large-cap portfolio, and 32 percent of the total domestic equity portfolio, which is $10.9 billion. We have a mix of active and passive management in each of the major asset classes. In international equity, we have $1.7 billion in index investments, which is about 41 percent of the international large-cap, and 35 percent of the international portfolio. In fixed income, we have $1.3 billion in index investments, which is 19 percent of the fixed-income portfolio. When you total those three categories, you come to about $6.7 billion, and our public market portfolio is about $24.1 billion, so that is about 28 percent in indexed assets. I believe there’s room for growth in the indexed portion of the portfolio. The only time you should be in an active strategy is if you believe that there’s a source of alpha—that the strategy can outperform. When we conducted our international equity rebalancing earlier this year, we were looking at not just the new managers we were adding, but also at that active/passive mix. In that rebalancing, the international equity portfolio stayed at about 67 percent active and 33 percent passive. In the original scenario, passive management was actually going to go much lower, but we made that decision to not bring it down so much. When we evaluate managers, we keep that passive index option in mind. We are comparing their performance not just to themselves and their peers within the active space but also to indexed portfolio performance. JOI: Are you using a core-satellite approach, with index-based investments at the core? Shah: Yes, that’s exactly right—that’s exactly how it’s been built. JOI: What kind of indexes are you using as the basis for your passive portion of the portfolio? Shah: In the domestic space, we have a growth index, a value index and a market-cap index. In international equity, we have the MSCI EAFE index. We’re looking into whether we should be also thinking of ACWI or the emerging index, and so on. Within fixed income, we have the Barclays Aggregate Bond Index. JOI: Do you believe that a passive strategy can be effective in emerging markets? Shah: It’s under consideration. Right now we have only 38 November / December 2012
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Page 3: Contributors Mark Abssy Mark Abssy
Page 6 and 7: STOXX LIMITED INNOVATIVE INDEXING.
Page 8 and 9: People’s futures are in your hand
Page 10 and 11: ©2012 Morningstar, Inc. All rights
Page 12 and 13: Exchange-traded products span a wid
Page 14 and 15: Figure 5 Median notional Volume ($B
Page 16 and 17: the put spread in this example is $
Page 18 and 19: The Loch Ness Monster. Sightings of
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Page 60 and 61: Morningstar Index Funds U.S. Style
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Page 70 and 71: ©2012, THE NASDAQ OMX GROUP, INC.
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