Replicating benchmark performance for passive mandates can be a challenge for some indices. Benchmark replication uses an optimized basket of equity futures to replicate benchmark performance when it is difficult to invest directly.
There are a number of strategies that can involve benchmark replication with equity futures:
- Synthetic equity uses equity futures instead of cash equities for passive index exposure. The strategy will free up cash that can be used to meet additional objectives such as increasing portfolio income and matching liability interest rate exposure.
- Cash equitization overlays equity futures on top of portfolio cash to lessen performance drag and tracking error.
Equity benchmarks are typically investible using futures contracts, but with varying levels of difficulty and operational burden. Benchmarks such as the S&P 500 are easily investible through a single futures contract and do not require a sophisticated replication methodology. Benchmarks such as the MSCI All Country World Index (ACWI) involve using multiple futures contracts to replicate, requiring a more sophisticated replication methodology to closely match the benchmark.
When replicating a benchmark using a basket of futures contracts, it may be unclear which contracts to use and what weights to assign to minimize tracking error. SLC Management has a proprietary process to identify what it believes to be the optimal mix of futures to replicate a given benchmark. The weights are updated periodically as the identified optimal mix changes over time.
A futures contract is an agreement to buy or sell an underlying asset at a certain point in the future, referred to as the expiry. The purchaser of the contract is agreeing to buy the asset at expiry and the seller is agreeing to sell the asset at expiry. To keep their exposure past the expiry date, a futures investor will close out of the position prior to expiry and roll forward to a date further in the future.
Futures require posting initial margin up front, which is a percentage of the notional value of the contracts. The position will mark-to-market daily through variation margin.
Example: Replicating MSCI ACWI
Replicating the performance of the MSCI ACWI requires a basket of futures contracts since there is no single futures contract that directly replicates this benchmark. For demonstration purposes only, our research indicates that using S&P 500, MSCI Europe, Australasia and Far East (EAFE) and MSCI Emerging Markets (EM) futures contracts are sufficient to replicate this index.
MSCI ACWI replication performance
*1/1/2010-12/31/2019
*The hypothetical Replication performance assumes an underlay of investments whose performance tracks the reference benchmarks in different weightings as in the manner described above over the periods shown. It is shown for illustrative purposes only. An investor may not invest directly in an index.
| Annual return | Annual SD | |
|---|---|---|
| MSCI ACWI | 8.79% | 13.1% |
| Hypothetical Replication (LHS) | 8.75% | 13.1% |
| Tracking Error | 0.46% |
| Index | Average weight |
|---|---|
| S&P 500 | 47.7% |
| MSCI EAFE | 38.8% |
| MSCI EM | 13.5% |
Considerations for the futures rebalancing process
Analysis for futures rebalancing will be performed during the development process to find the identified optimal mix of futures to replicate the benchmark. The process takes into account the balance between minimizing tracking error and transaction costs. Rebalancing more frequently will also lower tracking error in isolation but increase trading costs, which poses a long term drag on performance. Tracking error should be monitored on an ongoing basis and periodic analysis performed to rebalance the replication basket.
Futures contract vetting framework
Different contracts vary greatly in key metrics that determine their suitability for use in a benchmark replication strategy. Potential futures contracts are divided into a three tier system based on the following criteria:
- Daily average volume
- Daily open interest
- Bid/offer spread
- Trading hours
- Trading exchange risk profile
Tier 1 contracts: Currently eligible for most mandates
Tier 1 contracts are futures contracts that have high daily average volume, significant open interest, tight bid/offer spreads, ample trading hours and are traded on a reliable exchange. These are generally the universe of futures contracts that are used when developing synthetic equity and cash equitization strategies.
Tier 2 contracts: Suitable for some mandates, potentially tier 1 in the future
Tier 2 futures contracts have some Tier 1 characteristics, but not all five required. However, these contracts are monitored on a regular basis to determine if they should be moved to Tier 1. Tier 2 contracts could be used in synthetic equity and cash equitization strategies in small allocations when necessary under special circumstances. Tier 2 contracts could be used more regularly in the future once they qualify for inclusion in Tier 1.
Tier 3 contracts: Ineligible for most mandates, monitored for development
Tier 3 futures contracts that failed to meet majority characteristics of their Tier 1 counterparts. These futures contracts are believed to have little chance to ever be deemed appropriate for client portfolios. These contracts are judged to be severely deficient for one or more reasons. Typically they have very little open interest or very wide bid/offer spreads.
The tiers of some futures contracts can vary based on the size of the account. For example, a contract that has a low daily volume and trades on a reputable exchange may not be suitable for a large exposure but may be appropriate for a small exposure.
In summary, equity futures can be a useful instrument in replicating passive equity benchmarks while meeting other portfolio objectives such as offsetting liability interest rate risk or reducing performance drag from holding cash. For benchmarks not represented by a single futures contract, SLC Management has a proprietary process to identify what it believes to be the optimal mix of futures to replicate a given benchmark.
This paper is intended for institutional investors only. The information in this paper is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this paper.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association. Registration as an investment adviser does not imply any level of skill or training.
Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives involves leverage and could lose more than the amount invested. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
The overlay strategies are only available to Eligible Contract Participants as defined in Commodity Exchange Act Section 1 (a) (18). There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
The use of derivatives may expose a portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of March 31, 2020. Unless otherwise noted, all references to “$” are in U.S. dollars.
Nothing in this paper should (i) be construed to cause any of the operations under SLC Management to be an investment advice fiduciary under the U.S. Employee Retirement Income Security Act of 1974, as amended, the U.S. Internal Revenue Code of 1986, as amended, or similar law, (ii) be considered individualized investment advice to plan assets based on the particular needs of a plan or (iii) serve as a primary basis for investment decisions with respect to plan assets.
This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are current as at the date of the paper unless separately stated. All data is subject to change.
No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
© 2020, SLC Management
