If an investor has decided to manage asset class exposures passively, a choice needs to be made to implement these exposures either physically or synthetically. Physical investment is where an index manager is hired to manage the asset class (or subasset class) exposures. Synthetic exposure is where a derivative is used to replicate the return pattern of the required index, to provide economic exposure to the desired asset class.
In this chapter, we discuss the variety of different instruments to obtain and manage index exposures, and the effectiveness of and risks inherent in each instrument. Particular focus is placed on synthetic implementation and liquidity risks. An example of how derivatives can be employed to manage market and active management risks, often referred to as alpha-beta separation, is explored.
The main options for physical implementation of an asset class via index exposures are either index funds or exchange-traded funds (ETFs).
- Index funds provide index exposure through the purchase of all securities that underlie the index, where possible, or through a subset of those securities that closely track the index. Either approach usually results in a low tracking error to the index exposure sought. It is typical for index funds to provide daily net asset values and daily liquidity.
- Exchange-traded funds, like index funds, provide fully funded physical implementation. While the investment exposure provided by ...