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


  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:

  1. Daily average volume
  2. Daily open interest
  3. Bid/offer spread
  4. Trading hours
  5. 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.