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Using Futures in a Passive Portfolio

Futures analysis should provide actionable information that can be used to reduce tracking error or construct more effective hedges.

By Drew J. Cronin

With the increased attention on passive strategies, some portfolio managers are looking to futures for quick, inexpensive exposure to the market. But are they using futures effectively and are futures serving their intended purpose?

The key word here is “purpose”: What are your intentions and what elements are within your control?

Futures analysis should align with the decisions made in managing the portfolio and provide actionable information that can be used to reduce tracking error or construct more effective hedges.

To evaluate the success of futures in a portfolio we focus on three primary categories: cash equitization, leverage and futures mismatch. 

Cash Equitization

Portfolios hold cash due to uninvested inflows, dividends, and income; settlement cash; cash on hand for redemptions and withdrawals; and regulatory requirements, among other reasons.

That cash causes a drag on performance, increasing tracking error and lowering beta. All else equal, cash results in lower returns in upmarkets and higher (less negative) returns in downmarkets as the portfolio is not fully invested.

Futures can offset this drag on performance, providing exposure to the market and “equitizing” the cash position. The cash exposure is hedged with an allocation to a futures contract that mimics the benchmark’s performance. 


Any discrepancy between the futures position and the cash position results in leverage. A futures allocation larger than cash results in excess leverage (or overequitization), increased beta, higher returns in upmarkets and lower returns in downmarkets.

A futures allocation less than cash is a partial hedge (or underequitization), allowing a drag from the unequitized portion of the cash balance.

As the market moves and the composition of your portfolio changes, it’s important to monitor your futures allocation to avoid inadvertent changes to the leverage and beta of your portfolio.

Futures Mismatch

While cash equitization and leverage evaluate the impact of futures allocations, futures mismatch evaluates the impact of the selected futures and how closely they replicate the performance of your benchmark.

Common reasons why futures may not mimic the performance of the benchmark are:

Mismatched Underlying: Futures may not actively trade your stated benchmark. In such cases, we 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 results from a futures contract not moving perfectly in line with its underlying index. As the spread between the current spot price and future price changes, the performance of the futures contract will differ from the performance of the underlying.

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.

Roll Effect: Roll yield is the return generated as a futures contract converges to the expected spot price and can be considered a component of basis risk.

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 further-out date.

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 impacts the ability to properly equitize cash and replicate the performance of the benchmark. 


Cash drag and equitization, implied leverage, and futures mismatch are key factors to consider when determining the effectiveness of futures in your portfolio.

Proper decomposition of the underlying drivers of performance allows for optimal transparency, provides valuable insight into your portfolio construction and implementation process, and highlights the need for a more effective hedging or a better cash equitization process.

Futures can be an effective way to gain the market exposure you’re looking for, but ongoing oversight and evaluation of the effectiveness of hedging or equitization via futures is critical to ensure they’re serving their intended purpose. 


Drew J. Cronin is Vice President/Senior Product Strategist – Analytics at Factset.

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