ETF futures have grown in popularity with the increased adoption of standard exchange-traded funds.
An ETF is a financial instrument that tracks the performance of an underlying asset. A commodity, an index, or even currencies are examples of such assets. ETFs must be highly correlated to the asset they are tracking in order to function properly. Many funds use derivatives to accomplish this, such as options, swaps, and forwards, but futures contracts are one of the most popular.
- What is a futures contract?
- Example:
- How do futures ETFs work?
- Risks involved with futures ETFs
- How do I go about trading futures?
- In summary
What is a futures contract?
If you want to invest in ETFs, you need to learn more about the underlying assets they’re made up of.
A futures contract is a legally binding agreement to buy or sell a certain security, asset, or commodity at a defined price at a future date. They are exchanged and tracked on a regulated exchange, such as the New York Mercantile Exchange for example.
When a futures contract is purchased, the buyer assumes the responsibility to purchase and receive the underlying asset when the contract expires. The seller of a futures contract assumes responsibility for providing and delivering the underlying asset at the contract’s expiration date.
Unlike forward contracts, futures contracts are standardized and heavily regulated. Forwards are similar to futures contracts in that they lock in a future price in the present, but they are traded over-the-counter (OTC) and feature terms that can be customized by the participants. Contracts for futures, on the other hand, will have the same terms regardless of who the counterparty is.
ETFs are made up of a variety of contracts covering a variety of assets. There are futures for commodities, such as gold and oil, currencies (US dollar, Euro, Yen, etc), stock indexes, and bonds (interest rate plays for both short- and long-term positions are available).
Hedgers and speculators are the two most common types of market participants who utilize futures contracts. Both buyers and producers of an underlying item can use futures to hedge or ensure the price at which the product is sold or bought, while traders and portfolio managers can use futures to wager on the price fluctuations of an underlying asset.
Example:
Assume an oil company intends to generate one million barrels of oil in the coming year. In 12 months, it will be ready for delivery. Assume the current price of a barrel is seventy dollars. The manufacturer can produce the oil today and sell it one year later at today’s market pricing.
Due to the volatility of oil prices, the market price at the time could be significantly different from what it is now. If an oil company believes that the price of oil will rise in a year, it may choose not to fix the price today. However, if they believe seventy dollars is a decent price, they could buy into a futures contract to secure a fixed sale price.
How do futures ETFs work?
Futures-based ETFs are passively managed index funds that invest in futures contracts in order to attempt to replicate the performance of an underlying index.
An ETF (a firm) will buy futures contracts and then sell them to investors as a securitized version. The ETF does not own the underlying asset; instead, it trades contracts to keep the futures ETF afloat. The fund will buy contracts in order to match the index it is supposed to track.
ETFs may employ futures contracts that roll over when the opportunity occurs to provide some flexibility in tracking an asset. This allows the fund to stay up to date with market conditions and maintain tracking precision. Keep in mind that futures aren’t flawless, so there may be tracking inaccuracies in the ETF from time to time.
Futures-based ETFs offer many of the same advantages as traditional ETFs, such as being easy to trade, diversification, transparency, and cost-effectiveness.
Simultaneously, they also gain exposure to a wide range of underlying assets, including commodities (such as precious metals and other physical commodities), fixed income instruments, and equities, through the use of futures contracts.
Risks involved with futures ETFs
There are always associated risks with any investment. Prices change, as does the value of your assets, so it’s wise to consult a financial advisor or a managed futures broker before making any trade, futures or otherwise.
The accuracy of futures is one of its major drawbacks. Futures are structured to closely track the price of an underlying asset, but because they have a temporal value due to a future expiration, interest rates play a role. Price changes are also influenced by actual vs. perceived worth.
Prices fluctuate, interest rates vary, and traders hold differing viewpoints. All of these can lead to an erroneous tracking of the underlying asset in a futures contract. In layman’s terms, this is referred to as a tracking error. Tracking errors can be divided into two categories:
- When the futures price is greater than the spot price (current market price), it is said to be in contango.
- When the futures price is lower than the spot price, this is known as backwardation.
The objective of a futures contract is to track the underlying asset, however, errors can occur due to the factors mentioned above. It can also produce a tracking problem in an ETF if the fund uses futures to achieve its goal.
There is also a statutory position restriction that limits the holding of futures contracts traded on the recognized exchange company to a certain number of contracts. If a futures-based ETF’s holdings of such futures contracts reach a certain threshold, the ETF’s capacity to create units may be limited due to the difficulty of acquiring additional futures contracts.
As a result, there may be discrepancies between the trading price and the NAV of ETF units posted on the exchange.
Finally, relevant parties (including clearing or execution brokers, stock exchanges or participating dealers) can impose certain mandatory restrictions for risk management purposes on the ETF’s futures contracts in adverse market conditions.
Limiting the amount and number of the ETF’s futures positions, as well as obligatory liquidation of a portion (or all) of the ETF’s futures contracts without prior notice to the ETF’s operator, are examples of these restrictions.
How do I go about trading futures?
You may be able to trade futures depending on your broker and your account status with that broker. You’ll need to apply for and be accepted for a margin account. Qualified traders in the United States will frequently be able to trade futures on exchanges such as the Chicago Mercantile Exchange (CME).
In summary
Now that you know why futures are integrated into ETFs, don’t be alarmed if you notice futures in the mix when you examine the contest of your ETF, but be aware of why they’re there, how they work, and their restrictions.
As an investor, you should read the offering document thoroughly, particularly the product key facts statement, to fully comprehend the nature, investing aim and strategy, index information, fees and charges, key features, and major risks of a futures-based ETF.
You should consider if the product is right for you based on your financial goals, the amount of money you need to invest, and your risk tolerance. If you are unsure, always consult a financial advisor or a managed futures broker before making any trade, futures or otherwise.
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