If an investor has decided to manage asset class exposures passively, a choice needs to be made to implement these exposures either physically or synthetically. Physical investment is where an index manager is hired to manage the asset class (or subasset class) exposures. Synthetic exposure is where a derivative is used to replicate the return pattern of the required index, to provide economic exposure to the desired asset class.
In this chapter, we discuss the variety of different instruments to obtain and manage index exposures, and the effectiveness of and risks inherent in each instrument. Particular focus is placed on synthetic implementation and liquidity risks. An example of how derivatives can be employed to manage market and active management risks, often referred to as alpha-beta separation, is explored.
The main options for physical implementation of an asset class via index exposures are either index funds or exchange-traded funds (ETFs).