Three Ways to Ensure You’re Using Futures Effectively in a Passive Portfolio

Futures are a tool commonly used by passive managers to provide cheap exposure and to hedge or equitize portions of their portfolio. But how do we determine when a manager is using futures effectively and whether they’re serving their intended purpose?

The key word here is purpose. Wherever possible we want to attribute the impact of futures to the manager’s intended purpose and the elements within the manager’s control. For futures analysis to be valuable, it should align with decisions that the manager is making and provide actionable information that can be used to reduce tracking error or construct more effective hedges.

While it is difficult to imply the manager’s intent, we can quantify the impact of their decisions. This is done by decomposing the futures’ allocation and underlying return components to better align with the implicit and explicit impacts on the portfolio’s return and the futures’ ability to track the applicable benchmark.

Here we focus on three primary categories of futures’ impacts: cash equitization, leverage, and futures mismatch.

1) Cash Equitization

Day-to-day management of a portfolio will result in a cash balance for a number of reasons.   Uninvested cash inflows/dividends/income, settlement cash, cash for redemptions/withdrawals, and regulatory requirements, are only a few.

Cash balances cause a drag on portfolio performance as any difference between the portfolio’s cash position and the benchmark’s cash position (typically zero) increase tracking error and result in a low Beta relative to that benchmark, all else equal. Given an otherwise perfectly indexed portfolio, cash results in lower returns in upmarkets and higher (less negative) returns in downmarkets because the portfolio isn’t fully invested.

Example 1.A - Despite equal equity returns between the portfolio and benchmark, the cash balance causes the portfolio to drift from the benchmark returns.

Futures are often used in passive portfolios to equitize cash and offset this drag on performance. To eliminate the performance drag, we look to hedge the cash exposure with an equal allocation to a futures contract that looks to replicate the benchmark’s performance.

Example 1.B – A futures weight that offsets the cash balance and matches to the benchmark equity return serves to equitize the cash balance, resulting in equal portfolio and benchmark total returns.

2) Leverage

Any discrepancy between the futures weight and the cash weight results in leverage. Futures weights greater than cash weights provide positive leverage (equitization in excess of the cash drag) whereas an underweight to futures relative to cash de-levers (or allows some cash drag to remain) relative to a perfectly equitized portfolio.

As shown in the previous example, the first 10% allocated to futures offsets the 10% weight in cash. Any excess allocation will lever up the portfolio and increase Beta (higher returns in upmarkets and lower returns in downmarkets):

Example 2.A – The 15% futures weight relative to 10% cash adds excess leverage, higher tracking error, and more volatile returns. In effect, the 15% futures weight can be viewed as 10% cash equitization and 5% excess leverage.

Conversely, an underweight to futures relative to cash de-levers the portfolio, i.e. allowing a drag from the unequitized portion of the cash balance. 

Example 2.B – The 8% futures weight relative to 10% cash weight de-levers the portfolio relative to a perfectly equitized portfolio with 10% in both cash and futures. This can also be viewed as an 8% cash equitization and a 2% residual (unequitized) cash drag.

3) Futures Mismatch

For the proceeding cash equitization and leverage sections, we assumed that the futures were a perfect equitization vehicle with returns equal to the equity benchmark we’re looking to match. In practice, that’s not actually the case, and we must evaluate how well the futures replicate the performance of the benchmark.

While cash equitization and leverage can be considered futures allocation effects, driven solely by the weighting of futures, futures mismatch is in effect a futures selection effect, driven by the difference in return of futures relative to the benchmark they’re intended to replicate.

The reasons why futures are not likely to be an exact replication of the benchmark can be broken down as follows:

Mismatched Underlying – How well does the underlying index, or combination of underlying indices, correlate to the benchmark? Outside of larger, broad market indices, futures may not trade for the passive portfolio’s stated benchmark. In such cases, managers will use futures for the closest proxy index or a series of futures and other derivatives in an attempt to mimic the benchmark.

Basis Effect – Basis risk accounts for the fact that a futures contract does not move perfectly in line with its underlying index. As the spread between the spot and future price widens or narrows, the performance of the futures contract will differ from the performance of the underlying.

We can isolate the impact of a futures contract (priced based on the expected price of the underlying index at some future date) being used to replicate today’s performance of the benchmark. All else equal, as a future gets closer to expiration the spread between the spot and future price will narrow. This results in a positive (negative) excess return from time given a normal (inverted) futures curve.

Basis Effect = Change in futures contract price vs. change in current spot price

Roll Effect – Roll yield is the return generated as a futures contract converges to the expected spot price. Roll yield could be considered a component of basis risk, but we can gain additional insight by isolating the two as separate impacts.

Roll yield results in positive excess return relative to the underlying in a normal backwardated futures market and negative excess return in a contango market.

Roll Effect = Change in expected future spot price vs. change in futures contract price

Rollover Effect – Rollover yield occurs when a futures contract is renewed, or rolled, into a new contract. This typically occurs as a current contract approaches expiration and is settled and replaced with another contract for a date further out.

When a contract is rolled there will be differences in the price of the old and new contract based on time to expiration and different expected future spot prices. This forward premium or discount can be used to calculate the impact of rolling into new futures contracts on the ability to properly equitize cash and ultimately replicate the performance of the benchmark.

Example 3 – The futures returns of 18% and -10% fail to replicate the benchmark returns of 20% and -15%, resulting in weighted total mismatch effects of -0.2% and 0.5%. That impact of selecting futures that don’t replicate the benchmark can be broken down further into the tracking error of the underlying index, the basis effect, the roll effect, and the rollover effect.

Conclusion

To fully understand the impact and applicability of using futures in a passive portfolio, we must first be able to quantify the causes of tracking error. Cash drag and equitization, implied leverage, and futures mismatch are three key factors to consider.

If futures are used to hedge or equitize cash, ongoing oversight and evaluation of the effectiveness of those decisions is critical. Understanding potential impacts and being able to decompose the underlying drivers of performance allows for optimal transparency, provides valuable insight into the portfolio construction and implementation process, and highlights the need for a more effective hedges or a better cash equitization process.