When it comes to equities and fixed income, both markets historically have had more periods of positive returns than periods of negative returns. Over longer-term time horizons, the effect is even more pronounced. Hence, investors, whether they be large institutional investors such as a pension plan or money manager or individual investors, have an aversion to holding too much cash in reserves.

While it is true that holding cash can be a positive in terms of protecting a portfolio in a down market, it is a major performance drag if the market should continue to advance as it has for much of recent history. 

If the market were to advance even by a small amount, say 5% over the next few years, holding cash reserves will guarantee underperforming the benchmark (such as the S&P 500) as cash currently yields less than 1%. True, cash would give you reserves to invest in any potential bargains should the market decline, but in a bull market cash is not true value. In general, most portfolio managers take the long view and believe that the markets will advance. After all, why invest if you believed the market would suffer negative returns?

A pension plan or a money manager can combat cash drag by using a technique called cash equitization, which makes putting excess cash to work much easier. The primary tool for implementing a cash equitization strategy is stock index futures contracts. Their exceptional liquidity, low transaction costs, and nearly 24-hour availability makes them an excellent vehicle for equitizing cash. 

A portfolio manager (PM) that runs an S&P 500 Index mutual fund (a fund that exactly duplicates the S&P 500 by buying each of the members in the index) finds out that he has $1,200,000 to invest. The portfolio manager receives this information around 2 p.m. Central Time (CT)—an hour before the market closes.

Since he runs an index fund he must be fully invested at all times or he risks underperforming his benchmark: the S&P 500. If the PM failed to invest the $1,200,000 in cash and the market were to open and subsequently close higher the next day, he runs the risk of underperforming the market since he would be invested in cash instead of the stocks that make up the S&P 500 index.

The solution: equitize the $1,200,000 in cash using E-mini S&P 500 futures contracts. Simply put, cash equitization is a strategy whereby an investor can transform his cash into an investment that will track his benchmark; in this case, the S&P 500.

Each E-mini S&P 500 futures contract is worth about $120,000 in notional value (assuming E-mini S&P 500 is priced at 2400). So, the manager would have to buy 10 futures contracts to equitize the entire $1,200,000 in cash.

Since the S&P 500 futures correlate extremely highly with the underlying index, he now has fully invested the cash and will not have to worry about tracking error relative to his S&P 500 benchmark.

A portfolio manager (PM) that runs an S&P 500 Index mutual fund (a fund that exactly duplicates the S&P 500 by buying each of the members in the index) finds out that he has $1,200,000 to invest. The portfolio manager receives this information around 2 p.m. Central Time (CT)—an hour before the market closes.

FACTOID: Since the launch of S&P 500 futures back in 1982, one of the more popular uses of stock index futures has been to manage the excess cash in equity portfolios. Since then, many large pension plans and money managers use stock index futures as their primary cash equitization tool.

Since he runs an index fund he must be fully invested at all times or he risks underperforming his benchmark: the S&P 500. If the PM failed to invest the $1,200,000 in cash and the market were to open and subsequently close higher the next day, he runs the risk of underperforming the market since he would be invested in cash instead of the stocks that make up the S&P 500 index.

The solution: equitize the $1,200,000 in cash using E-mini S&P 500 futures contracts. Simply put, cash equitization is a strategy whereby an investor can transform his cash into an investment that will track his benchmark; in this case, the S&P 500.

Each E-mini S&P 500 futures contract is worth about $120,000 in notional value (assuming E-mini S&P 500 is priced at 2400). So, the manager would have to buy 10 futures contracts to equitize the entire $1,200,000 in cash.

Since the S&P 500 futures correlate extremely highly with the underlying index, he now has fully invested the cash and will not have to worry about tracking error relative to his S&P 500 benchmark.

Using E-mini S&P 500 futures to manage cash can have other benefits as well. If the manager were to have redemptions (investors selling their shares in exchange for cash), he could merely sell any S&P 500 futures that were in the portfolio. By doing this, he avoids selling stocks and thereby losing any dividends. 

Cash equitization is a very commonly used strategy by pension funds, endowments and other money managers. It can also be utilized in fixed income portfolios as well since cash drag exists in bond portfolios too.