tirsdag den 28. oktober 2008

Rebalancing - chances of three day rally

Dear Investors,

This is not even a "real blog" but I have to make you aware that potentially this month-end could be the biggest rebalancing going on since "crahs of 1987" - the following is an internal e-mail I did to explain - very simplistically what goes on! (Please, please do not send me email why its wrong, but accept the "drivers" of this totally mechanical process' which has ironically made most funds lose more money....but that's another story.

Rebalancing – the way most long only fund managers do their portfolio management is to hedge themselves versus a benchmark – for arguments sake let’s make this index:

60% stocks and 40% fixed income.

From end of September the performance has been:

Russel2000: - 34% month to date
EAFE International stocks: -30% month to date
Lehman +20 yrs bonds: +2%

A “standard portfolio” consists of:40% domestic bonds – here represented by TLT US Index, 60% stocks – where 75% is domestic (RTY index) & 25% foreign EAFE (MXEA) ---

now the math starts:

Assuming fund manager by start of October was balanced as per above his p&l looks like this:

Oct 1: AUM 100 USD.
TLT (Bonds) 40 USD
RTY (Domestic stocks) 45 USD
MXEA(Foreign stocks) 15 USD….

Oct 28th though:

TLT = 40.8 USD (+2%)
RTY= 29.5 USD (-34%)
MXEA= 10.5 USD (-30%)

In order to get back to Oct 1 “ratio” the fund manager needs to (look at 4th coloumn):

TLT 40.8 32.4 -8.4 -6.804
RTY 29.7 36.45 6.75 5.4675
MXEA 10.5 12.15 1.65 1.3365
TOTAL 81 81

He/she needs to:

Sell 8.4% of 81 USD worth of bonds or 6.8 USD worth
BUY 5.5 USD worth of domestic stocks
BUY 1.3 USD worth of foreign stock.

This is Totally mechanical and the closer we get to Friday the more this could play.

We have bought November call 1010 for 10.00 USD to play this – or 500 US Dollar per contract.

References: S&P @ 873.00, Stoxx50 @ 2355

Safe trading


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