How Futures and ETFs Work Together
As you know, ETFs track an underlying asset. Be it a commodity, an index, or even a currency, for ETFs to be effective, they need to correlate pretty closely to their desired product. And in order to do that, many funds utilize derivatives. Although options, swaps, and forwards are sometimes included in ETFs, it is futures contracts that are implemented the most.
So, if you are going to invest in ETFs, you need to know what is actually in an ETF. And with that in mind, let’s explore one of those components: futures.
The Basics of Futures
A futures contract is an agreement between a buy and a seller based on an underlying asset. The seller agrees to deliver the asset to the buyer at a future date, but the price of the asset is determined on the date of the actual agreement.
Here is an example: It's currently October, and you want to buy a November oil future for $95. The seller takes your $95, and on November’s expiration, he technically owes you a barrel of oil. Will you actually get a barrel of oil? Probably not, but you will be compensated based on the price of oil on that particular day.
Futures contracts are formed on many 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 with your long position:
- You can sell your futures contract back to the seller (or another trader) before expiration. You may want to do this if the price of oil rises and you want to lock in a profit. Or if it gets too low and you want to get out of the position for a minimal loss.
- You can wait until expiration and exercise your right to have oil at $95. In most cases, you will get the profit or take the loss in your account. So if the future is worth $195, you will get back your $95 plus another $100 in profit (filtering out fees and other costs). Or you may get less if the price is lower than the original trade.
- 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. This can be done with the original seller or another trader.
- Technically you could demand your barrel of oil, but as you can guess, that never happens. Too many factors involved like freight and inconvenience.
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, your trades, your profit and loss, your margins, and your fees. They handle the logistics behind rollovers and expirations as well.
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.
There are also futures exchanges throughout the world like the Eurex (Europe), London International Financial Futures and Options Exchange, and the Tokyo Commodity Exchange.
The Benefits of Using Futures in ETFs
Unlike an index or other assets, an ETF is a pre-packaged mini-portfolio designed to track an index without having to battle the price of a basket or gain exposure to a commodity without creating a cattle farm on the front lawn. But because these funds are pre-packaged, there is not any active management (with apologies to actively managed ETFs).
So in order 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 and thereby maintain accuracy. However, as stated above, futures are not perfect, and this can cause tracking errors in the ETF at times.
But all in all, futures do 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 related to trading. And without a doubt, many funds utilize futures to make the ETF achieve its goal.
Added Risks With Trading Futures
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 with an expert such as a financial advisor or a managed futures broker.
However, one particular issue with futures is their accuracy. This has been a heated debate lately, especially about commodity futures. Futures are designed to track the price of an underlying asset accurately, 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.
As we said, prices change, interest rates move, and traders have different opinions. All of this can cause a futures contract to correlate with the underlying asset inaccurately. This is what’s known in common language as a tracking error, and there are two types of errors:
- Contango: when the futures price is actually higher than the spot 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 as well if the fund uses futures to accomplish its goal.
Now you know why futures are sometimes 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.