Narach Investment

USING FUTURES IN ASSET ALLOCATION


Transaction costs are the main hindrance to the active or tactical asset allocation process. The transaction cost has to be paid for whether the investor is buying or selling to accomplish a shift in the asset mix of his portfolio.

The investor can do the same buying (calling) and selling (putting) through futures to accomplish the same changes in the asset mix of his portfolio. With the added advantage of not necessarily changing the underlying assets in his portfolio. But, to accomplish this he would have to create a cash reserve within the portfolio to provide for the margins he would have to pay on the futures trades. So, in a sense he would be incurring an opportunity loss on the funds not deployed in stocks or bonds. And, further would have to provide for and compensate the portfolio for this opportunity loss.

Futures may be and are used from time to time to accomplish shifts in the portfolio composition. The advantages are:

  1. Minimum transaction cost.
  2. High liquidity and fast execution.
  3. One day settlement and simultaneous trades.
  4. Does not disrupt the management of the underlying assets.
  5. Potential of favorable mis-pricing.
However, there are also disadvantages in the use of futures:
  1. Potential of unfavorable mis-pricing.
  2. Large quantum of back office work required, to record all transactions on a daily basis.

A cash reserve is required to pay for margins on futures. So, to provide for this a part of the stock or bond holding is liquidated. Here, we have an opportunity loss on these funds, and would have to be provided for.

For a better understanding of futures and options, the investor may find it interesting to read about the role of options and futures and what are options?