Track an index with futures only: what to do with the cash?

Question

Suppose your mandate is to track S&P500. Suppose the mandate size is $ 1,352,500. The contract size of the future is 50, today's index price is 2705. If I buy 10 contracts my exposure will be exactly similar as the fund's size.

(to simplify imagine you don't have to post margins for counterparty risk).

Apparently doing this would still result in a high tracking error because of the cash position, I don't understand this, can someone explain?

Answer 1

This should help:

[A] long position in a futures contract implies a short position in dividends and repo rates, as reflected by the minus signs in the futures pricing equation for the dividend and repo rate terms. This means that any decline in dividend expectations and/or repo rates increases the value of futures contracts, all other things being equal. In the same way, any rise in dividend expectations and/ or repo rates reduces the value of futures contracts.

[...]

The futures roll index ignores some real-life costs faced by investors. First, a futures buyer may not be able to earn interest at a rate that matches the rate used in the futures cost of carry calculation. Any shortfall in interest earned, by comparison with the interest expense assumed in the futures calculation, will result in return slippage, vis-à-vis the index, for the futures buyer. Second, the futures roll index assumes that no initial margin is payable on a futures position. Third, the roll index ignores the effects of bid-offer spreads and commissions payable when futures are rolled each quarter.

[...]

In the last two years, however, the return on the futures roll index has lagged that of the Euro STOXX 50 gross total return index by 94 basis points a year. Why? The reason is a fall in the futures implied repo rate (the third component of the futures cost of carry calculation) into negative territory.

Source: http://www.lyxor.com/uploads/tx_bilyxornews/140120-BRO-ETF-Swap-Future-HD-internet_02.pdf