In this issue

  • What is synthetic equity?
  • Benefits of a synthetic equity strategy
  • Case study: Equity plus – return enhancement

Synthetic equity is the replacement of a cash equity exposure (such as ETFs) with equity futures contracts. By using this strategy, an investor frees up cash that can be better used to meet strategic mandates, such as income enhancement or duration goals.

In addition, holding this freed-up cash in local currency investments can help minimize the foreign exchange risk associated with owning foreign equities.

A synthetic equity strategy can help investors who wish to maintain passive equity exposure while seeking one or more of the following:

  • Liquidity pool. Generate an additional source of funds to enhance portfolio liquidity.
  • Reduce foreign exchange risk. Passive equity futures contracts minimize the foreign exchange risk associated with foreign equity holdings.
  • Low transaction costs. These contracts provide “cheap beta,” with low transaction costs and without the management fees and expenses associated with cash equity products.
  • Generate higher portfolio yield. Fixed income products can provide an additional and predictable source of portfolio income.
  • Improve portfolio duration matching. Extending portfolio duration by adding bonds is especially useful for key rate duration matching for liability driven investors.

Equity futures contracts

Equity futures contracts replicate many global indices, such as the S&P 500, Euro Stoxx 50, CSI 300, MSCI World and more. They are exchange listed, generally highly liquid, and trade in three-month contracts that are rolled quarterly.

The initial margin is an upfront deposit that can be met with a range of eligible collateral. Variation margin may be required depending on market conditions, with a daily mark-to-market of the contract that is settled in cash. 

Case study: Equity plus – return enhancement

An institutional investor, who is looking to generate additional returns in their risk seeking portfolio, has a strategic allocation to both active and passive equity. Passive mandates provide equity beta to the portfolio while the active equity allocation strives to provide additional return via alpha versus benchmarks.

The current passive allocation is based on a local index (TSX60) plus global indices for diversification (S&P 500 and Euro Stoxx 50). Replacing the passive equity beta with equity futures generates cash that can then be used to purchase short-dated fixed income securities. The additional credit spread earned on the cash portfolio can help outperform traditional passive beta strategies.

Equity ETF ≈ Equity Futures + Liquidity Pool

Similar to a forward contract, futures have an implied financing rate. Earning an investment rate on the freed up cash greater than the implied financing rate of the futures can lead to the strategy outperforming the cash index or ETF.

Forward Price = Spot Price * (1+implied financing rate-estimated dividend yield)^(days/365)

For example, and for illustrative purposes only, to replace the XIU ETF with SPTSX 60 futures, you:

  1. Sell the ETF
  2. Buy SPTSX 60 listed index futures contracts with implied financing of 3m CDOR -20bps
  3. Invest the proceeds into a portfolio of short-dated corporate bonds and government bonds with an expected return of 3m CDOR +25bps
  4. Based on this hypothetical example and for illustrative purposes only, indicatively outperform the index benchmark by +45bps1

To replace foreign-denominated cash equity holdings (S&P 500 and Euro Stoxx 50) with futures contracts, you:

  1. Sell the EUR denominated Euro Stoxx 50 ETF and USD denominated S&P 500
  2. Buy S&P 500 and Euro Stoxx 50 listed index futures contracts
  3. Invest the proceeds in Canadian denominated short-term bonds and cash
  4. Eliminate FX risk on the principal amount of the foreign investment, and maintain FX risk only on daily gains and losses on equity futures
  5. Avoid ETF management fees and enhance income

Strategy comparison

Customize your liquidity strategy

Flexibility is a key benefit of a synthetic equity strategy. The portfolio liquidity created can be used to match specific investor needs and preferences. As these needs change, the liquidity plan can be redesigned to meet them.

We’d be pleased to discuss the needs of your plan and the liquidity strategies that can help.

1 For illustrative purposes only. All investments involve risk including the possible loss of capital. The use of derivatives may expose the 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. 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.

This document is intended for institutional investors only. The information in this document 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 presentation.

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.

The use of derivatives may expose the 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. 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.

Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of June 30, 2020. Unless otherwise noted, all references to “$” are in U.S. dollars.

Nothing in this document should (i) be construed to cause any of the operations under SLC Management to be an investment advisory 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 presentation 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.

© 2021, SLC Management