Fixed Income Research

Replicating Index Returns with Treasury Futures

November 1997 Lev Dynkin 212-526-6302 ldynkin@lehman.com Jay Hyman 212-526-0746 jay@lehman.com Wei Wu 212-526-9221 wwu@lehman.com

Summary
We introduce a framework for replicating the returns of standard or customized Lehman Brothers bond indices by matching the term structure exposure of an index with a futures overlay. We analyze the distribution of security durations in an index to determine the mix of the four Treasury futures contracts that best matches the yield curve exposure of the index. We use the Lehman Brothers multifactor futures model to calculate option-adjusted durations of futures contracts. Our methodology has performed well in historical simulations and in actual trading programs. Using historical data from January 1994 through July 1997, it tracks the Lehman Brothers Aggregate Index within 10.5 bp per month including transaction costs. This could be cut by combining the futures position with a tracking portfolio of a few cash securities, especially in the MBS market.

AcknowledgementThe authors thank Don Regan for motivating this study and for his continued valuable input.

Publications: M. Parker, D. Marion, V. Gladwin, A. DiTizio, C. Triggiani, B. Davenport, J. Doyle This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. The information in this document has been obtained from sources believed reliable, but we do not represent that it is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 1997 Lehman Brothers Inc. All rights reserved. Member SIPC.

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INTRODUCTION
Money managers who take a passive stance against a broad-based benchmark regularly face the problem of maintaining a curve-neutral position as the portfolio size changes, due to fund inflows and outflows or asset allocation shifts. Because it is impractical to buy or sell many different issues at once, managers often seek a strategy to track their benchmark using a small set of liquid securities; thus, they can quickly and easily invest money and withdraw it as needed. Treasury bond and note futures offer investors an opportunity to better manage interest rate risk and maintain liquidity. These markets have sufficient volume for large positions to be traded quickly with no adverse effect. By buying short-term securities and taking long positions in Treasury futures contracts, an investor can create a synthetic asset with a return profile similar to that of a portfolio of Treasuries. Using a futures overlay to bring a portfolio in line with its benchmark may be advantageous in many situations. When new money flows into a benchmarked portfolio, the first concern is to position portfolio duration (neutral, long, or short according to the investors view) relative to the benchmark. Similarly, when the investment mandate or the benchmark changes for an existing portfolio, using futures to adjust the portfolio exposures can be preferable to buying or selling core assets. In addition, portfolios are sometimes constrained to maintain significant cash positions for liquidity purposes. Futures can be used to help earn index returns on these cash positions. By taking a position in a single futures contract (e.g., 10-year notes), an investor can match any desired duration target. This basic form of tracking with futures mimics the performance of the benchmark in response to parallel shifts in the yield curve, but leaves room for significant performance differences in the event of nonparallel shifts.

To replicate the performance of a broad-based market index requires matching its exposures to all segments of the Treasury yield curve. Lehman Brothers has developed a strategy to track any of its fixed income indices using a combination of the four futures contracts on Treasury securities (2-, 5-, 10-, and 30-year maturities). By analyzing the distribution of security durations in an index, we determine the mix of contracts that will best match the yield curve exposure of the index. For indices with significant exposure to spread sectors, we use this strategy to replicate the rate-driven portion of returns. Because this strategy offers no exposure to spreads, we expect more deviation from benchmark returns than for the Treasury Index. Our replication strategy, which matches the interest rate exposures of an index while leaving intact any exposures to spreads, can also be used as a hedging technique. Investors who wish to take on exposure to a particular spread sector can enter into an index swap that pays the return on a selected index. By taking short positions in futures according to the replication strategy, they can hedge the interest rate portion of the index returns. This combination of index swaps and futures provides a powerful mechanism for managing portfolio exposures to credit spreads. This report presents the replication strategy, along with historical simulations and the strategys performance replicating the returns of various Lehman Brothers indices. All numerical results include the effect of futures transaction costs, according to the conservative assumptions described below.

PERFORMANCE SUMMARY
The performance of the strategy in replicating the Lehman Brothers Treasury Index over the last 3 years (1/947/97) is summarized in Figure 1. Over this period, the

Figure 1.

Performance of Replication Strategy vs. Hedging with a Single Futures Contract, including Transaction Costs, Tracking the Lehman Brothers Treasury Index, January 1994-July 1997, in bp with monthly rebalancing
Monthly Total Returns Index Futures Portfolio Average Std. Dev. Average Std. Dev. 50.9 134.2 48.9 148.0 50.9 134.2 48.3 152.3 50.9 134.2 52.2 145.6 50.9 134.2 52.0 124.9 50.9 134.2 50.9 135.1 Monthly Return Difference (Tracking Error) Average Std. Dev. Var. Explained -2.0 44.7 88.91% -2.6 26.2 96.20 1.3 19.9 97.79 1.1 22.6 97.16 0.0 6.7 99.75

Hedge Method 2-year Futures Only 5-year Futures Only 10-year Futures Only Bond Futures Only Replication Strategy

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strategy matched the average index return of 50.9 bp per month over the long term, with a tracking error (standard deviation of return difference) of 6.7 bp/month. The standard deviation of index returns is 134.2 bp/month. Accordingly, the replicating portfolio captures 99.75% of the return variance of the index. Using a mix of all four Treasury futures contracts, the strategy tracks the index more closely than an approach of duration-hedging using any single futures contract. The hedge using only the 10-year note, which performs best of the four singlecontract hedges, provides a tracking error of 19.9 bp/ month over the same period, explaining only 97.8% of return variance. Figure 2 shows how closely this strategy tracks the index through wide variations in index returns. Figure 3 summarizes the strategys performance versus several Lehman Brothers indices. As applied to indices with progressively greater exposure to spread product, the strategy shows two effects. First, the return shortfall of the
Figure 2.
Returns (%) 6

futures strategy compared to the selected index increases. This reflects the spread earned by the index, which is often reflected in higher coupon returns. Second, the tracking error increases because our method hedges only yield curve exposure, not spread exposure. A detailed discussion of replicating indices with large spread product components follows later in this report. But even leaving spreads unhedged, our strategy achieves a tracking error of only 10.5 bp/month versus the Lehman Brothers Aggregate Index, capturing over 99% of its return variance.

METHODOLOGY
Allocate to Duration Cells . . .
The first step of our replication process is to divide the Treasury Index into 4 duration cells and establish a correspondence between these cells and the Treasury futures contract of matching duration. The under 3-year duration cell is matched with the 2-year futures contract, 3-5 years with the 5-year contract, 5-7.5 years with the 10-year contract, and 7.5 years and higher with the 30-year contract. We then take the notional value of the replicating portfolio (the amount of money on which we would like to earn the return of the index) and divide it based on market capitalization into amounts to be matched against each of the duration cells. For each such cell, we calculate the dollar duration of the indicated investment to be replicated by taking positions in a single futures contract and a cash instrument. This process is illustrated in Figure 4. In this section, we are using as our example replication of the Treasury Index returns for July 1997. The market value of the 0-3 year duration portion of the Lehman Brothers Treasury Index is shown as $897,696 million, or 42.45% of the total index market value of $2,114,600 million. The weighted average modified-adjusted duration of this cell was 1.80 years. Assuming that the notional market value of our hypothetical portfolio is $100,000,000,

Performance of Futures Replication Strategy vs. Lehman Brothers Treasury Index

Strategy Treasury Index

-2

-4
Difference (bp) 100

50 0 -50 -100 1/94

7/94

1/95

7/95

1/96

7/96

1/97

7/97

Figure 3.

Performance of the Replication Strategy vs. Selected Lehman Brothers Indices, January 1994-July 1997
Monthly Total Returns on Index (bp) Average Std. Dev. 50.9 134.2 53.7 141.6 55.0 130.9 58.5 112.1 61.8 165.9 Monthly Returns on Replication Strategy (bp) Average Std. Dev. 50.9 135.1 52.1 141.6 52.1 132.5 52.7 116.5 54.9 162.5 Monthly Return Difference (Tracking Error, in bp) Average Std. Dev. Var. Explained 0.0 6.7 99.75% -1.6 8.0 99.68 -2.9 10.5 99.36 -5.8 27.8 93.83 -6.9 18.0 98.82

Avg. DurIndex Tracked ation (yr.) Treasury 4.99 Gov/Corp 5.33 Aggregate 5.14 Mortgage 4.82 Corporate 6.26

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42.45% or $42,452,2611 will be assigned to the 0-3 year duration cell, and the dollar duration of this investment will be $76,414,069 ($42,452,261 x 1.80). This market value and dollar duration will serve as targets for replicating this cell using Treasury 2-year note futures and cash.

. . . and Match Dollar Duration

For each duration cell, we assume that 98% of the notional value is invested in 3-month Treasury bills (part of this investment may be used for initial margin); the other 2% remains in cash for variation margin.2 Next, the dollar duration of the bill investment is subtracted from the dollar duration of the index cell to find the target dollar duration for the futures position. We then calculate the number of contracts required to provide that dollar duration. This calculation uses the effective duration of the futures contract as provided by the Lehman Brothers bond futures model. This two-factor model, which includes a precise valuation of the switch option, is described in the Lehman Brothers report, The Lehman Brothers Multifactor Futures Model, September 1997. Figure 5 shows this calculation for our example. The Treasury bill investment has a total market value of
1All numbers shown in this section have been calculated using full precision but are shown rounded to an appropriate decimal place for presentation. For example, the true percentage of the index in the 0-3 year duration cell is $897,695,538K/$2,114,600,074K = 42.452261%. 2This assumption reflects a simplified modeling of the margin rules for futures accounts. The initial margin requirement, which must be posted when a position is established, may be posted in the form of Treasury bills. Calls for variation margin, which may occur as the position is marked to market, would need to be paid in cash. We have conservatively assumed that 2% of the portfolio market value is set aside for this contingency, earning no interest.

$98,000,000, or 98% of the notional value of the replicating portfolio. Of this, 42.45% is applied to the 2-year cell (based on the index market weight from Figure 4). At an assumed duration of 0.25 years, this gives a dollar duration of $10,400,804. Subtracting this amount from the target dollar duration of $76,414,069 calculated in Figure 4 gives a new dollar duration target of $66,013,266 for the 2-year contract. The dollar duration per contract is then computed by multiplying the contract duration by the contract price and face value (1.70 x 103.008% x $200,000 = $350,980). Dividing the target dollar duration by the per contract dollar duration and rounding to the nearest whole gives 188 contracts. Figure 6 gives a position summary of the entire replicating portfolio. The market value of the portfolio is split between the bill investment and the cash reserves, while the duration exposure is provided by the combination of bills and long futures positions.

HISTORICAL SIMULATION
We tested the portfolios performance with a historical simulation: a basket of futures was chosen at the start of each month to track an index, and the positions performance was measured at the end of each month relative to the index. We were conservative in reflecting such effects as transaction costs, margin requirements, and contract rolls within the constraints posed by the monthly nature of the simulation. Our assumptions avoid any artificial overstatement of the strategys performance.

Figure 4.

Replication of the Lehman Brothers Treasury Index as of 6/30/97

Allocation of market value and dollar duration along the curve for $100,000,000 notional value Index Adjusted Duration (yr.) 1.80 3.81 6.19 10.83 4.83 Notional Portfolio Mkt. Val. ($) 42,452,261 20,903,342 15,009,077 21,635,320 100,000,000 Portfolio Dollar Duration at Notional Mkt. Val. ($) 76,414,069 79,641,734 92,906,186 234,310,516 483,272,506

Duration Index Composition Cells Mkt. Val. ($ mill.) % Less than 3 yrs. 897,696 42.45 3-5 yrs. 442,022 20.90 5-7.5 yrs. 317,382 15.01 7.5 yrs. and higher 457,500 21.64 Total 2,114,600 100.00

Futures Contract UST 2-yr UST 5-yr UST 10-yr UST 30-yr

Figure 5.

Calculating the Number of Futures Contracts to Replicate the Lehman Brothers Treasury Index as of 6/30/97
Targeted Futures Dollar Dur. $66,013,266 74,520,415 89,228,963 229,009,863 458,772,506 Futures Contract Duration 1.70 yr. 3.77 5.32 9.36 Futures Contract Price 103.008 105.891 107.875 111.063 Contract Face Value $200,000 100,000 100,000 100,000 Contract Market Value $206,016 105,891 107,875 111,063 Futures Number Contract of Dollar Dur. Contracts $350,980 188 398,960 187 573,966 155 1,040,025 220

T-bill Position T-bill Futures Market Value Dollar Contract (98% of Notion.) Duration 2-year $41,603,216 $10,400,804 5-year 20,485,275 5,121,319 10-year 14,708,895 3,677,224 30-year 21,202,614 5,300,653 Total 98,000,000 24,500,000

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Figure 7 shows how performance was measured for July 1997 for our replicating portfolio, including transaction costs on the futures contracts. For each component of the position that was established at the start of the month, settlement prices from the beginning and end of the month are used to calculate profit and loss. The results are summed across the position, the costs of the futures transactions are netted out, and the remainder is divided by the beginning market value to compute a net position return, which can then be compared with the indexs monthly return.
Figure 6.

Our assumptions for transaction costs are shown in Figure 8. For the purposes of measuring performance, we assume that futures contracts are bought just above the listed settlement price on the last business day of the month, adding a bid/ask spread of 1/64 for the 2- and 5-year contracts and 1/32 for the 10-year and bond contracts. When positions are liquidated, we use the listed settlement prices. For each of the four contracts, we assume a $10 per contract commission each way to cover the costs of execution and clearing. Thus, the total transaction cost for rolling a single bond contract

Position Summary of Replicating Portfolio for the Lehman Brothers Treasury Index as of 6/30/97
Amount Price 98.606 100.000 103.008 105.891 107.875 111.063 Market Value $97,999,573 $2,000,427 0 0 0 0 100,000,000 Duration 0.25 0.00 1.70 3.77 5.32 9.36 4.83 Dollar Dur. $24,499,893 0 65,984,275 74,605,460 88,964,729 228,805,566 482,859,924

Cash Securities UST 3-month bills (includes initial margin) Cash reserves (for variation margin) Futures Contracts UST 2-year note futures UST 5-year note futures UST 30-year note futures UST bond futures Position Total

$99,385,000 2,000,427 188 187 155 220

Figure 7.

Measuring the Performance of the Replicating Portfolio for July 1997

Face Value Price Begin 98.606 100.000 End 99.130 100.000 Return 0.53% 0.00 P&L $520,777 0 520,777 37,600,000 18,700,000 15,500,000 22,000,000 103.008 105.891 107.875 111.063 103.742 107.984 111.000 116.750 0.71 1.98 2.90 5.12 276,125 391,531 484,375 1,251,250 2,403,281 2,924,059 $2,403,281 $520,777 ($524) $2,923,534 Beginning Market Value Overall Return Treasury Index Return Return Difference $100,000,000 2.924% 2.868% 0.056%

Cash Securities UST 3-month bills Cash reserves Total P&L on cash securities: Futures Contracts UST 2-year note futures UST 5-year note futures UST 10-year note futures UST 30-year bond futures Total P&L on futures: Position Total P&L on Futures Positions P&L on T-bill Investment Transaction Costs Overall P&L No. of Contracts Contract Face 188 $200,000 187 100,000 155 100,000 220 100,000

$99,385,000 2,000,427

Figure 8.

Estimating the Transaction Costs of Rebalancing the Futures Position to the Lehman Brothers Treasury Index at the Start of July 1997
Assumed Cost of Spread per Contract Bought $31.250 15.625 31.250 31.250 Total Commission Assumed per Contract Bought or Sold $10.00 10.00 10.00 10.00 Number of Contracts Needed for Replication 188 187 155 220 Number of Contracts in Position from Prior Month 189 172 164 224 Number of Contracts Bought (Sold) (1) 15 (9) (4) 29 Total Assumed Transaction Cost $10 384 90 40 524

Futures Contract UST 2-year note futures UST 5-year note futures UST 10-year note futures UST 30-year bond futures Total

Assumed Bid/Offer Spread 1/64 1/64 1/32 1/32

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from one calendar month to the next would include $10 commission on the sale of the front contract, and $10 commission and $31.25 of spread ($100,000 face x 1/32) on the purchase of the back contract, for a total of $51.25. This analysis was carried out against several of Lehman Brothers fixed income indices, using monthly return data from January 1994 through July 1997. At the end of each month, the cash position was rolled into the

most recent 3-month Treasury bill, and the futures position was rebalanced versus the index. Once per quarter, just before the start of the delivery month, the futures positions were rolled to the next contract. In the intervening two months of the quarter, only minor adjustments to the futures position were made. Figure 9 shows the monthly trading history for replicating the Treasury Index for the entire period. The bulk of the transaction costs were incurred during the quarterly roll to the next contract.

Figure 9.

Monthly Transaction Log for Simulated Replication of $100,000,000 Notional in the Lehman Brothers Treasury Index
Contract Deliv. Mo. 2-year Mar-94 168 Mar-94 166 Jun-94 170 Jun-94 183 Jun-94 187 Sep-94 178 Sep-94 185 Sep-94 189 Dec-94 188 Dec-94 196 Dec-94 192 Mar-95 184 Mar-95 183 Mar-95 195 Jun-95 190 Jun-95 198 Jun-95 194 Sep-95 185 Sep-95 183 Sep-95 192 Dec-95 188 Dec-95 186 Dec-95 189 Mar-96 186 Mar-96 181 Mar-96 186 Jun-96 185 Jun-96 192 Jun-96 202 Sep-96 200 Sep-96 197 Sep-96 202 Dec-96 200 Dec-96 200 Dec-96 200 Mar-97 186 Mar-97 192 Mar-97 196 Jun-97 192 Jun-97 193 Jun-97 180 Sep-97 189 Sep-97 188 Index Replication Positioning Contracts 5-year 10-year 30-year 204 147 212 209 144 206 200 158 212 217 140 206 211 135 210 215 139 205 209 135 202 207 132 206 201 140 204 208 122 200 204 119 192 207 140 194 206 139 201 207 142 197 196 139 206 194 137 203 211 128 205 193 145 211 192 146 209 200 147 202 189 137 214 183 139 217 183 134 213 172 135 213 166 145 213 174 137 208 176 142 216 166 163 210 171 157 207 174 154 206 169 153 207 174 154 203 171 162 209 176 157 207 169 165 205 159 164 216 179 151 212 179 149 211 176 162 217 180 160 215 177 157 218 172 164 224 187 155 220 (Beginning of Month) Contracts Transact. Total Traded Cost 731 731 26,966 725 16 238 740 1465 34,650 746 54 1,212 743 19 440 737 1480 34,472 731 20 419 734 13 380 733 1467 34,436 726 37 729 707 19 190 725 1432 33,742 729 10 319 741 20 684 731 1472 34,501 732 15 400 738 32 648 734 1472 34,642 730 6 91 741 25 688 728 1469 34,487 725 13 286 719 12 214 706 1425 33,625 705 21 523 705 26 541 719 1424 33,959 731 44 1,315 737 24 631 734 1471 34,929 726 10 131 733 15 416 742 1475 35,266 740 12 198 739 17 420 725 1464 34,812 734 43 930 735 7 195 747 1482 35,414 748 9 184 732 22 314 749 1481 35,529 750 29 524 Returns (End of Month) Futures Index Return Return Diff. 1.45% 1.38% 0.07% -2.01 -2.15 0.14 -2.25 -2.24 0.00 -0.80 -0.78 -0.02 -0.05 -0.12 0.07 -0.18 -0.22 0.05 1.91 1.82 0.08 0.13 0.02 0.11 -1.49 -1.40 -0.09 0.01 -0.06 0.08 -0.11 -0.20 0.09 0.65 0.61 0.04 1.83 1.85 -0.02 2.19 2.14 0.06 0.61 0.63 -0.02 1.34 1.31 0.03 3.94 4.04 -0.10 0.78 0.79 -0.01 -0.38 -0.37 -0.01 1.17 1.16 0.01 0.95 0.96 -0.01 1.55 1.55 0.01 1.53 1.55 -0.02 1.43 1.43 0.00 0.59 0.63 -0.04 -2.07 -2.05 -0.02 -0.97 -0.86 -0.11 -0.70 -0.64 -0.06 -0.21 -0.16 -0.05 1.35 1.27 0.08 0.19 0.24 -0.05 -0.23 -0.21 -0.02 1.64 1.64 0.00 2.18 2.20 -0.02 1.74 1.73 0.01 -1.17 -1.03 -0.14 0.14 0.10 0.04 0.05 0.12 -0.08 -1.19 -1.08 -0.11 1.51 1.44 0.07 0.91 0.86 0.04 0.97 1.12 -0.15 2.92 2.87 0.06 0.51 0.51 0.00 1.35 1.34 0.07

Month Jan-94 Feb-94 Mar-94 Apr-94 May-94 Jun-94 Jul-94 Aug-94 Sep-94 Oct-94 Nov-94 Dec-94 Jan-95 Feb-95 Mar-95 Apr-95 May-95 Jun-95 Jul-95 Aug-95 Sep-95 Oct-95 Nov-95 Dec-95 Jan-96 Feb-96 Mar-96 Apr-96 May-96 Jun-96 Jun-96 Aug-96 Sep-96 Oct-96 Nov-96 Dec-96 Jan-97 Feb-97 Mar-97 Apr-97 May-97 Jun-97 Jul-97 Average Std. Dev.

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TRACKING SPREAD SECTOR INDICES

Using Futures Alone . . .
Our strategy combining cash and futures can essentially replicate the Lehman Brothers Treasury Index. Our historical testing shows returns that are on average approximately equivalent to the index, with a small tracking error. This is to be expected, since the pricing of both the Treasury Index and the futures are ultimately based on the cash markets for U.S. Treasury notes and bonds. This technique can be applied to broader bond indices as well but will not track as closely. Our all-Treasury strategy should be expected to underperform any spread sector index on average and to show an increased tracking error due to spread volatility. Nevertheless, since the movement of the yield curve dominates performance even in the spread sectors, our futures strategy can track these indices fairly closely. Figures 10 and 11 show the strategys performance versus the Corporate and MBS Indices, respectively. The strategy underperforms the Corporate Index by 6.9 bp/month and the MBS Index by 5.8 bp/month on average (see Figure 3). As a check on these results, we calculated the historical excess returns of each index
Figure 10. Performance of Futures Replication Strategy vs. Lehman Brothers Corporate Bond Index
Returns (%)

over a basket of duration-matched Treasuries. To calculate excess return, we divided each index into tight consecutive duration cells. Within each cell, we subtracted the total returns on Treasuries from those of corporates, for example. We then recombined these percell excess returns based on the market weighting of the Corporate Index to calculate the overall excess return for the index. This excess return gives the total return advantage of owning a spread product asset class versus a duration-matched Treasury position, including the coupon advantage and the effect of any spread tightening or widening. Figure 12 shows that the historical risk and return characteristics of the various indices, as given by historical excess returns, correspond closely to the performance of our futures strategy against each one. Figure 12 also highlights the success of the strategy in tracking the Aggregate Index. Our attempts to track the Corporate and MBS Indices give tracking errors of 18.0 and 27.8 bp/month, respectively. Nevertheless, we achieve a tighter 10.5 bp/month against the Aggregate Index, due to a combination of two effects. First, approximately half the Aggregate Index is composed of Government securities, so the spread effect is diluted. Second, the Aggregate Index benefits
Figure 11. Performance of Futures Replication Strategy vs. Lehman Brothers Mortgage-Backed Securities Index
Returns (%)

6 Corporate Index Strategy 4

6 Mortgage Index Strategy

-2

-2

-4
Difference (bp)

-4
Difference (bp)

100 50 0 -50 -100 1/94

100 50 0 -50 -100 1/94

7/94

1/95

7/95

1/96

7/96

1/97

7/97

7/94

1/95

7/95

1/96

7/96

1/97

7/97

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Figure 12. Replication Strategy Results vs. Index Excess Returns, January 1994-July 1997
bp/month Monthly Index Monthly Excess Return Outperformance Relative of Index over Durationto Replication Strategy matched Treasuries Index to Track Average Std. Dev. Average Std. Dev. Treasury 0.0 6.7 -0.1 0.5 Gov/Corp 1.6 8.0 2.2 4.5 Aggregate 2.9 10.5 3.0 10.1 Mortgage 5.8 27.8 4.8 29.3 Corporate 6.9 18.0 8.4 16.9

Investors benchmarked to the Aggregate Index might feel that futures replication is sufficient for tracking the returns of Governments and corporates but that the tracking error against MBS is too high. In this case, they might use a proxy portfolio of mortgage pass-throughs to track the MBS component of this index, and rely on futures to bring the overall term structure risk in line with the Aggregate Index. (It is not necessary to take on the accounting burden of mortgage cash flows to take advantage of this approach; the liquid market in mortgage rolls allows investors to achieve MBS exposures without taking settlement.) To test this approach, we used our proprietary risk model (see the forthcoming publication, The Lehman Brothers Multifactor Risk Model ) to select a proxy portfolio of 10 or fewer MBS pass-throughs to match the MBS Index at the start of each of the last four years. For example, in January 1997 the model selected a proxy portfolio of seven MBS pass-throughs to track the Lehman Brothers MBS Index of 609 generic pass-throughs (based on sector, coupon level, and year of issuance). As shown in Figure 13, the model projected a systematic tracking error of 13.4 bp/month for this portfolio. This compares favorably with the 27.8 bp/month tracking error achieved by our replication strategy. We then used our replication strategy to design an overlay of futures and 3-month bills to bring the term structure exposure of the position in line with the Aggregate Index. The core MBS position was rebalanced annually, while the futures and bill positions were rebalanced monthly to the Aggregate Index. As shown in Figure 14, this strategy replicated the Aggregate Index more closely than our Treasury-only strategy, improving the tracking error from 10.5 bp/month to 7.3 bp/month.

from diversification. Within either the corporate or mortgage market, there is a reasonable likelihood that spread shock will affect the entire index. This is less likely for the Aggregate Index because spread changes in the corporate market are not highly correlated with those in the mortgage market. These two effects combine to lower the volatility of the spread component of return in the Aggregate Index.

. . . or Combining with Other Instruments

Some investors may need to track a spread sector index more closely than is possible using our all-Treasury strategy. Depending on the needs and constraints of the investor, several other approaches are available. First, the short-term vehicle used to invest cash can be changed from Treasury bills to corporate paper of any quality. Second, various forms of derivatives can help sculpt the desired return profile. Lehman Brothers can enter into a swap or create a structured note that will pay the total return on any desired index. Similarly, a spread swap can be structured in which Lehman Brothers will pay the total return on the Corporate Index while the client pays the return on the Treasury Index. Such a swap, in conjunction with a futures-based replication of the Treasury Index, provides an alternative mechanism for achieving Corporate Index returns without the need to purchase corporate bonds. For other investors, futures may be a tool for managing risk in a liquid fashion. Futures can be used effectively with a core position in the relevant cash market. If the overall market value of the portfolio is expected to be reasonably stable, an investor can establish a position in corporate bonds, for example, and use the combination of futures and short-term securities to keep the portfolio aligned with the Corporate Index as assets flow in and out. Lehman Brothers

Figure 13. Tracking Error Analysis for MBS Proxy Portfolio vs. Lehman Brothers MBS Index,
January 1997 Tracking Error Isolated Cum. Chg. in 0.071 0.071 0.071 0.133 0.000 0.071 0.000 0.000 0.071 0.000 0.000 0.071 0.000 0.000 0.071 0.000 0.139 0.148 0.077 0.076 0.153 0.005 0.085 0.134 -0.019 0.134

Tracking Error Term Struct. Non-Term Str. Tracking Error Sector Tracking Error Quality Tracking Error Optionality Tracking Error Coupon Tracking Error MBS Sector Tracking Error MBS Volat. Tracking Error MBS Prepaym Total Systematic Tracking Error

November 1997

The agency mortgage-backed market is amenable to the proxy portfolio approach. A portfolio with a fairly small number of securities can track the index closely, as the primary source of risk is systematic exposure to term structure and prepayments. In the corporate bond market, the nonsystematic risk stemming from large exposures to individual issuers typically requires a greater number of issues for the same level of tracking. For a comprehensive treatment of the construction of MBS proxy portfolios, see the Lehman Brothers report, Replicating the MBS Index Risk and Return Characteristics Using Proxy Portfolios, March 6, 1997.

30-year bond and 10-year note futures. The hedging mechanisms considered fall into two categories: duration-based hedges, in which matching dollar duration remains the primary mechanism for controlling risk; and regression-based hedges, in which we find the hedge that would have performed best over recent history, even if it is not perfectly matched in duration.

Duration-matched Hedges
We examine three hedges in which the dollar duration of the futures position is matched to that of an investment in the notional amount of the index. These hedges use bond futures, 10-year note futures, and a combination of the two. A duration hedge using bond futures alone is equivalent to our original strategy involving four duration cells. This is in some sense the natural hedge for this index. Thirty-year bonds alone would be expected to provide a better hedge than 10-year notes alone since the bond contract is matched more closely to the term structure exposure of the index. Over the period studied, the duration of the Treasury 20+ year Index averaged 11.06 years, compared to 5.75 years for the 10-year contract and 9.88 years for the 30-year contract. Thus, obtaining the same duration exposure as the index using 10-year note futures requires buying contracts representing 1.96 times the notional value. The duration of bond contracts is closer to that of the index, allowing a smaller hedge ratio; it averaged 1.12. The results of these different hedging strategies are shown in Figure 15. The hedge using

TRACKING LONG DURATION INDICES

Our replication strategy based on index allocations to four duration cells will never generate a short position in any futures contract. For indices with extremely long durations, this may limit the strategys ability to match index exposure to steepening or flattening of the yield curve. For example, the Lehman Brothers Treasury 20+ year Index falls entirely into the longest of our four duration cells. Our strategy would thus amount to a pure single-contract duration hedge using the bond futures contract. Because the duration of the index is longer than that of the bond contract, this hedge is unable to match exposure to nonparallel yield curve shifts. To address this issue, we have investigated several methods for hedging this index using a combination of

Figure 14. Using Futures with a Core Position in MBS to Improve Tracking of the Lehman Brothers Aggregate Index January 1994-July 1997
Monthly Total Returns (bp) Index Replicating Strategy Average Std. Dev. Average Std. Dev. 55.0 55.0 130.9 130.9 53.3 52.1 128.1 132.5 Monthly Return Difference (Tracking Error, bp) Variance Average Std. Dev. Explained -1.8 -2.9 7.3 10.5 99.69% 99.36

Method Replication Strategy Overlay over an MBS Proxy Portfolio Replication Strategy Alone

Figure 15. Tracking the Lehman Brothers 20+ Year Treasury Index Using Various Replication Methods January 1994-December 1996
Std. Dev. of Monthly Percent. Outperof Variance formance (bp) Explained 91 89.85% 28 99.02 20 99.50 17 99.65

Replication Method Duration Hedge using 10-year note futures Duration Hedge using 30-year bond futures Mixed Duration Hedge using 10-year and 30-year futures Regression Hedge using 10-year and 30-year futures

Average Hedge Ratio Mean Monthly 10-year 30-year OutperContracts Contracts formance (bp) 1.96 0.00 5 0.00 1.12 2 -0.58 1.46 3 -0.17 1.15 6

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10-year note futures gave a tracking error of 91 bp/month versus the index, capturing nearly 90% of the variance of the index returns. As expected, we were able to track the index more closely using bond futures, achieving a tracking error of 28 bp/month and capturing more than 99% of index return variance. An analysis of why the 10-year note hedge performs poorly can point the way to improving the bond futures hedge. Our method of matching the dollar duration of the 20+ index with a larger position in 10-year futures should provide a reasonable hedge against parallel shift risk but remains exposed to twists between 10- and 30-year yields. This theory is consistent with the widely accepted understanding that roughly 90% of the variance of yield curve movement is due to parallel shift. While the duration of the bond futures contract is closer to that of the index, it is shorter than the index. A flattening of the curve will produce a rally in the index that will not be matched by the bond futures hedge. To remedy this effect, we designed a third durationmatched hedge using a mix of 10-year and bond futures that is constrained to match the index exposure to a 10-30 twist in the yield curve as well as to parallel shift.3 This mixed hedge is characterized by overweighting the bond futures beyond the pure hedge and offsetting the extra duration by a short position in 10-year futures. Using this hedging technique, we improved tracking error to 20 bp/month.

return data. A regression of returns on the two futures contracts against the return on the index over the preceding n months provides the set of hedge ratios that would have tracked best over this historical window. These hedge ratios are then used to establish the futures position for the coming month. We varied the number of historical months from 12 to 30 and found little sensitivity to this parameter. The results shown in Figure 15 used a 24-month look-back. The regression hedge often exhibits overexposure to bonds along with a short of the 10-year note, as seen in the duration-matched hedge using a mix of the two contracts. The regression-based hedge proved to be fairly stable and achieved a tracking error of 17 bp/month. However, regression-based hedging techniques require caution. Relying on historical returns data produces a lag in the response of the hedge to market changes. If the relationship between the durations of index and futures contracts changes suddenly, the regression-based hedge could become severely mismatched in duration. Therefore, we favor the mixed duration hedge. Its performance against the sample data set is not as good as the regression hedge, but it captures most of the improvement offered by including a second futures contract in the hedge while safely matching duration. The success of the regression-based hedging technique at tracking the Lehman Brothers Treasury 20+ year Index led us to question how such techniques would perform in a more general setting. We applied this technique to our original problem of tracking the Lehman Brothers Treasury Index using four futures contracts. As shown in Figure 16, this technique produced a tracking error of 13.6 bp/month, more than double the 6.7 bp/ month achieved by our replication strategy, which matches dollar durations along the curve.

Regression-based Hedge
In the regression-based approach, we once again hedge the index using a mix of 10-year and 30-year futures. In this case, the hedge ratios for the two contracts are set at the start of each month based on analysis of recent historical
3 To specify the hedging techniques used in this section, we define the hedge ratios 10 and 30 as the percentage of notional index market value to be placed in the 10- and 30-year contracts, respectively. For all techniques considered, we constrain the duration of the futures position to match that of the 20+ index:

CONCLUSION
Replication of index returns using Treasury futures can be customized in several ways to meet the investment needs of clients. The benchmark can be any of the Lehman Brothers indices, or a custom benchmark formed by reweighting or redefining any subset of the Lehman Brothers Aggregate Index. The short-term security in which funds are invested may be selected by the client, and the duration of the futures position adjusted appropriately. Decisions about when to roll

10 D10 + 30D30 = D20+.

The hedge using only 10-year notes is obtained by 30=0; the hedge using bond futures alone corresponds to 10=0. For our mixed duration hedge, in addition to the above constraint which hedges exposure to parallel shift, we introduce an additional constraint that hedges exposure to a 10-30 twist in the yield curve. Assuming that the yield change caused by this twist for a given point on the curve is linear in duration, the hedge ratios must then also satisfy

10D10 D D20+ = 30 30D30 D20+ D10 .

When the duration of the 20+ year Treasury Index exceeds that of the bond contract (as it did over most of the period studied), the solution to this set of two equations gives 10<0 and 30>1.

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from one contract month to the next and when and how frequently to rebalance are left to the client. We have shown that a combination of Treasury futures and short-term securities can effectively replicate the returns of fixed income indices, within a small margin of error. This is true not only for the Treasury Index but for the Aggregate Index as well.

This methodology has been applied to index tracking and portfolio allocation for several clients of Lehman Brothers engaged in futures transactions and has lived up to the results expected from historical simulation. The success of the methodology might give investors an additional reason to use futures in asset allocation and risk management of index portfolios.

Figure 16. Performance of Regression Method and Replication Strategy vs. the Lehman Brothers Treasury Index January 1994-July 1997
Monthly Total Returns Index Replicating Strategy Average Std. Dev. Average Std. Dev. 50.9 134.2 52.9 132.2 50.9 134.2 50.9 135.1 Monthly Ret. Diff. (Track. Error) Variance Average Std. Dev. Explained 0.8 13.6 98.97 0.0 6.7 99.75

Method Regression method Replication strategy