An exchange-traded fund (ETF) tracks an underlying asset. The asset might be a commodity, an index, or even a currency. For ETFs to be effective, they need to correlate pretty closely to the asset they are tracking. To do that, many funds utilize derivatives. Options, swaps, and forwards are included in ETFs, but futures contracts on one of the more popular assets used in them.
So, if you are going to invest in ETFs, you need to know more about the asset that makes up many exchange-traded funds.
- Futures are contracts between a buyer and seller for a specific price at a specific date in the future.
- Futures are traded, tracked, and monitored on a regulated exchange like the Chicago Board of Trade or New York Mercantile Exchange.
- Exchange-traded funds can use futures as the assets that make up the fund.
- Futures ETFs give investors access to the futures market without having to trade on the futures markets.
The Basics of Futures
A futures contract is an agreement between a buyer and a seller based on an underlying asset. The seller agrees to deliver the asset to the buyer at a future date, but the asset's price is determined on the date of the actual agreement instead of the future transaction date.
Here is an example: It's currently October, and you want to buy a November oil future for $95. When the contract is due, the seller takes your $95 and gives you a barrel of oil. Will you actually get a barrel of oil? In this example of a future, yes, you're responsible for accepting the barrel. However, the futures contracts within ETFs are not these contracts; they are derivatives of those contracts.
ETFs are formed from many different contracts on different types of assets. There are futures for:
- Commodities: Oil, gold, orange juice (Remember Trading Places?)
- Currencies: Euro, US Dollar, British Pound, Yen
- Bonds: Interest Rate Plays for short and long term positions
- Stock Indexes: Both US and International
How Futures Work
Using our example, let’s say you are the owner of the futures contract (the buyer). You have four options for your long position.
Sell the Contract
You can sell your futures contract back to the seller (or another trader) before expiration. You may want to do this if you think the price of oil is going to rise and you want to lock in a profit. Or, it might threaten to get too low, causing you to want to get out of the position for a minimal loss.
Buying and selling contracts are how most futures trades are conducted. For example, an investor could sell one futures contract and buy it back a month later at a different price.
Wait for the Expiry Date
You can wait until expiration and exercise your right to buy the oil at $95. The profit or loss is credited or debited from your account. So if the future is worth $195, you're $100 ahead (before fees and other expenses). If the price is $85, you've overpaid for the barrel and technically taken a loss because you won't be able to sell it for the price you paid.
Roll the Contract
You could roll the contract over to another month. You “trade” in your current November contract for a new contract in December or another month. You can do this with the original seller or another trader.
Take the Asset
You could pay for and take your barrel of oil. This is typical if you work for a refinery, but it doesn't happen with traders and investors. Freight, storage, and finding another buyer are expensive and time-consuming.
Monitoring Trading and Futures Exchanges
Unlike forward contracts, futures contracts are heavily regulated. There are Futures Contract Regulations and a Commodity Futures Trading Commission. Also, there is a clearinghouse involved. They act as a bank and keep track of your account, trades, profit and loss, margins, and fees. They handle the logistics behind rollovers and expirations as well.
There are also futures exchanges throughout the world like the Eurex (Europe), ICE Futures Europe, and the Tokyo Commodity Exchange.
Futures trade on futures exchanges, just as stocks trade on stock exchanges. The more popular futures exchanges in the US are in Chicago and New York—Chicago Board of Trade, Chicago Mercantile Exchange, and New York Mercantile Exchange.
The Benefits of Using Futures in ETFs
An ETF (a company) will purchase futures contracts and then offer a securitized version to investors. The ETF doesn't take possession of the underlying asset but continues to trade contracts to keep the futures ETF running. The fund will purchase contracts so that it mirrors the index that it is designed to track.
What this means for investors is that a futures ETF is a pre-packaged mini-portfolio designed to track a futures index. This keeps them from battling the price of a basket or gaining exposure to a commodity without building a cattle farm or feed silo on the front lawn.
So to have some flexibility in tracking an asset, ETFs may use futures contracts that roll over when the opportunity arises. This helps the fund keep in line with current market conditions, thereby maintaining tracking accuracy. However, futures are not perfect, so there can still be tracking errors in the ETF at times.
As with any investment, there are risks. Prices fluctuate, as will the value of your assets, so before making any trade, futures or otherwise, it’s important to consult a financial advisor or a managed futures broker.
But overall, futures help make ETFs an attractive investment. They give investors access to certain markets or assets without the hassle of rollovers, expirations, multiple fees, basket-pricing, and many other factors (or headaches) related to trading. Futures ETFs are also continuing to evolve, with actively managed ETF futures popping up around the marketplace.
The Risks of Trading Futures ETFs
One particular issue with futures is their accuracy. Futures are designed to accurately track an underlying asset's price, but since these derivatives have time value due to a future expiration, interest rates are a factor. Also, actual vs. perceived value plays a role in price fluctuations as well.
Prices change, interest rates move, and traders have different opinions. All of this can cause a futures contract to track the underlying asset inaccurately. This is what’s known in common language as a tracking error. There are two types of tracking errors:
- Contango: when the futures price is higher than the spot price (the current market price)
- Backwardation: when the futures price is lower than the spot price
The goal of a futures contract is to track the related asset, but due to the factors above, these errors sometimes take form. And it can cause an ETF to have a tracking error if the fund uses futures to accomplish its goal.
Now you know why futures are built into ETFs, so don’t be scared when you “look under the hood” and see futures in the engine, but do be aware of why they are there, how they work, and their limitations.