Index Replication with Futures in a Deglobalized World

• Deglobalization could result in lower correlations and higher regional-market volatility, which may lead to higher tracking error when replicating the performance of indexes with a basket of local-index futures.
• Increased volume of multi-country, multi-currency futures linked to global and regional indexes make them an important tool to consider for index performance replication.
• Investors may wish to balance the potential benefit of index-performance-replicating futures with country and currency risk from using a basket of local-index futures.

There are a variety of potential methods when investors seek to replicate the performance of a global or regional index using index futures, depending on liquidity, transaction cost and tracking-error considerations. Some may choose to match the futures with the index they use to measure performance (which results in lower tracking error), while others could turn to local futures not directly linked to the index whose performance is sought to be replicated and currency forwards (while incurring tracking-error and associated operational risks).

High-risk, lower-correlation environment

We previously highlighted that deglobalization could result in lower correlations among countries with higher volatility. In such conditions, replicating indexes performance using a basket of local index futures could result in higher tracking error. The following exhibit shows a correlation heatmap for MSCI developed-market regional and country indexes over one- and five-year time periods, with country performance decoupling more in the last year than over the five-year period.

Correlation matrix

Correlations calculated based on weekly returns. June 1, 2016, to May 31, 2022.

A trade-off in tracking error occurs when selecting a basket of country or regional futures that collectively are designed to mimic the performance of an index, as opposed to futures linked to an index for matching purposes. If deglobalization trends persist with lower country correlations and higher volatility, investors may want to reassess the potential risks in using futures that deviate from the index they use to measure performance.

Case study: MSCI World and MSCI EAFE Index replication

To illustrate the risks in replicating indexes performance using a basket of equity futures and currency forwards, we simulated the performance of the MSCI World and MSCI EAFE Indexes (in USD) using local-regional and country indexes (as shown below). The selection of indexes was based on the largest geographic exposures with consideration to limit the number of indexes. While there are many other possible constructs, we use these indexes for comparative purposes. To assign weights to the selection of indexes, we ran an optimization that minimized the tracking error to the index.¹

Index and hedging index representation

As shown below, the replication of the performance of the MSCI EAFE Index had a higher tracking error than replicating the MSCI World Index (using their respective hedging indexes), reflecting the more diverse country weights of the MSCI EAFE Index. Replicating the MSCI World Index's performance using the MSCI EAFE and MSCI USA Indexes had much lower tracking risks than using narrower regional or local indexes. In addition, country and currency risks were elevated in the MSCI World Hedging Index A and the MSCI EAFE Hedging Index. Investors could weigh these outcomes relative to taking direct exposure to futures linked to MSCI World and MSCI EAFE Indexes after considering other factors such as liquidity and open interest.

Tracking risk for the hedging indexes

Data as of May 31, 2022.

Managing currency exposure in index replication

Essentially, we see three scenarios involving currency exposure to consider when attempting to replicate the performance of an index in a 100% currency-unhedged manner using futures:

1. Equity future and currency denomination are index-aligned. If the futures are linked to a index that matches equity and currency exposure, such as a USD investor using USD-denominated futures linked to the MSCI World Index, then no additional exposure is needed to be hedged.
2. Equity future is index-aligned, currency is not. If the currency denomination of the futures differs from the index, then a currency forward is needed to match exposures. For example, a GBP-based investor using the MSCI World Index looking for both equity and currency exposure, may consider exposure to both USD-denominated contract futures linked to the MSCI World Index and a USD-GBP currency forward.
3. Equity future is not index aligned. In this scenario, the investor would replicate the index performance using a combination of regional- and country-index futures. This would also require the use several non-base currency forwards based on the currency exposure in the index.

Unhedged currency exposure could result in significant deviations from the index's performance. This would have been the case for investors not hedging their USD exposure in 2022 (see below for index currency exposure and year-to-date returns).

Top-five currency constituents of the the MSCI World and MSCI EAFE Indexes

Data as of May 31, 2022.

The whole may be greater than the sum of its parts

While investors may aim to synthetically-replicate the performance of equity indexes using a basket of local-index futures and currency forwards, our simulations showed these had considerable country and currency risks that led to higher tracking error. This risk of tracking error also may be amplified by the higher country volatility and lower regional correlations due to recent trends in deglobalization. Multi-country, multi-currency futures may capture exposure to the performance of an index in a single contract with less tracking error than a partial replication. With the continued growth in multi-country, multi-currency futures, they could become a tool for a managing exposure to the performance of reference indexes in a deglobalized world.

¹ Barra Portfolio Manager (BPM).

Further Reading

Did Deglobalization Add to Inflation Woes?

Putting Futures to Work

Using multi-country multi-currency futures in portfolio management