pages 250-251 of CFAI: LOS § says “justify enhanced indexing on the basis of risk control”. How does the derivatives-based strategy control risk any differently than simply holding equity index futures? The example given is “equitize cash; add value by altering the underlying duration of the cash”.
I think “equitize cash” here means using cash to long a equity future. If I am wrong, just correct me.
First of all, from my understanding, derivatives-based consists of using equity index futures to go long on the desired equity market. Secondly, active return is gained by adjusting the duration of the fixed-income position (cash/bills/notes etc). By simply holding equity index futures, there is no component for active return (generating alpha). You simply get what the index gives you. By adjusting the duration of the cash position, you can play around with it depending on the yield curve and generate the incremental return. I just have a bit of a confusion with your question. What do you mean by “simply holding equity index futures?” as opposed to a derivatives-based strategy?. Derivatives-based strategy consists of going long equity index futures. Hope that made sense.
From what sparty419 said.
I think an investor should earn more than the equity index , when he goes “long equity index future” compared to “long equity index” (through buying actual stocks)…because the former (future) involves leverage which should enhance/magnify your return (as measured by ROE)!
Am I right here?
Also i would like to know that derivatives-based-enhanced indexing effectively means that an investor goes long equity index future (to earn Beta~1 +/- the leverage effect) and another long position in long-term/short-term bonds depending upon his expectations of the yield curve?
an at-the-money long future would return the exact same return as the underlying index less the risk free rate.
If an investor longs the at-the-money futures contract with a notional value = to their portfolio value and purchases a risk free bond that expires on the same day as the futures contract, it would be the same as buying into the index (ignoring transaction costs)
Future + Rfr Bond = Index
If the investor instead purchases s-t bonds that have a small amount of creadit risk involved the investor would earn a higher rate than the Rfr. therefore entering into the long future contract plus the s-t bond (instead of the Rfr Bond) he should be able to earn a higher return.
Future + S-T Bond = Index + (S-T Bond yield - Rfr)
If the investor sees better opportunities in longer duration bond (better expectations further out on the Yield curve) he may invest in longer term bonds instead of S-T Bonds to increase his risk adjusted return further.
FinNinja , you have a distinct leverage component in Futures .
Most of the time you only have to put up 15% margin to buy a futures contract versus at least 50% for buying an index position. This is why a futures contract is called a derivative. Your price return on the index is amplified by the leverage you have. That is built into the contract and creates a great deal of liquidity
I think the text may be referring to options where the premium may be higher than a futures margin but the returns can be outlandishly higher .
I wish they did not confuse the terms by pretending futures contract is not a derivative instrument.
I understood derivatives-based enhanced indexing as entering long futures at a notional = to portfolio mkt value and not using them to leverage the portfolio. If you were to only use futures for a pure indexing strategy this is how you would create it. I understood that the enhancement only came from the added return of the short term bonds over the risk free rate, is this incorrect?
I don’t have the book with me so I can’t check what it actually says.