The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

PORTFOLIO APPLICATIONS OF STOCK INDEX FUTURES

Now let’s look at how stock index futures can work with passive or active equity investment strategies. Our focus is on how stock index futures can be used to manage all types of equity strategies more efficiently. We begin by examining how futures can help change equity exposure in order to achieve the desired level of exposure at the lowest possible cost. The two strategies examined are hedging strategies (a special case of risk management) and asset allocation strategies.

Stock index futures contracts are often ideal instruments for managing equity exposure in passive or active strategies due to their liquidity, flexibility, and low transaction costs. An equity position of comparable dollar value can be managed in the stock index futures market at a fraction of the cost in the cash market. The futures market is also an alternative means of implementing an investment strategy to the cash market.

The choice of whether to use the cash market or the futures market to alter equity exposure depends on the objectives of the manager and the size of the equity exposure. Despite apparent cost advantages, there are limits to the amount of stock index futures available to large institutional investors such as pension funds due to regulatory, size, and liquidity constraints. Nonetheless, stock index futures can still be an effective and valuable tool for portfolio management.

The motivation behind the choice to change equity exposure is ...