An exchange-traded futures contract is an agreement to buy or sell an underlying asset on a specific future date, at a predetermined price. It may sound like a newfangled investment vehicle, but it’s really anything but.

Futures trading has a long history in the US, dating back to the mid-19th century when organized grain markets were established. A central marketplace enabled farmers to sell their commodities for either immediate delivery (spot trading) or forward delivery at a preset price. This helped farmers—who were often unsure what the future price of their crops would be—better manage their production risk. Today, futures are available not only for agricultural goods but also for financial instruments such as Treasury bonds, equity indexes, currencies, and more.

Futures trading in today’s market

Modern market participants use futures to accomplish different investment goals:

  • Hedgers use futures to mitigate unwanted business risk while still allowing them to prosper from their core business.
  • Speculators use futures to take a position with the hope of benefiting from a short-term market view.
  • Investors use futures to manage market exposure in a capital-efficient manner; examples include index funds reinvesting pending dividends and fund sponsors securitizing their cash and rebalancing their portfolios.

Let’s take a closer look at the key characteristics of futures and the implications for different types of investors.

Transaction costs for futures trading

Transaction costs for futures include commissions, market impact, and bid-ask spread. Transaction costs are often lower than those of comparable physical instruments. As margined instruments, futures have financing costs that may affect realized performance. A key advantage of futures is that the investor gains the asset-class exposure desired with only a small cash outlay for margin requirements. Initial margin is posted, and variation margin may be required in the event of a loss due to an adverse market move.

Available futures benchmarks

Investors can access various public-market benchmarks through a single futures contract or a basket of futures contracts, and futures are often more liquid than other vehicles, such as the underlying stocks in an index. Investors can also establish short futures positions to efficiently remove undesired exposure. Futures may not, however, be efficient vehicles for gaining exposure to private markets, such as hedge funds.

As the illustration below shows, taking a position in index futures plus cash can approximate an investment in the index’s underlying equities.

What Investors Should Know About Futures Trading Blog Image

Source: Parametric, 2019. For illustrative purposes only. Money market interest less the S&P 500 Index® futures premium creates an income stream nearly identical to that of the S&P 500 dividend yield.

Tracking error and futures

Index-based futures seek to mimic their benchmarks, but they may experience slightly different returns. As such, tracking error is an important risk to consider. Typically, the more specialized the index coverage, the more difficult it is for these instruments to successfully track the returns of the benchmark.

For exposures covered by a specific futures contract, tracking error is minimal. For exposures without a single contract, investors typically use a basket of futures contracts that will introduce some level of tracking error depending on how specialized the index or exposure is.

Futures’ flexibility and liquidity

Many futures contracts trade around the clock. This allows for trading outside standard market hours, increasing an investor’s flexibility to make exposure adjustments. Unlike most physical assets, futures have same-day liquidity. In other words, when a futures position is sold, the fund has access to the vast majority of the cash the same day. Futures, therefore, provide a great deal of flexibility and liquidity for plan sponsors and investors. These attributes make futures well suited for applications such as cash securitization and portfolio rebalancing.

The bottom line

“Futures” sounds like an abstract concept, but it’s really not. It has down-to-earth roots in America’s agrarian past and has merely been adapted to meet the liquidity and risk-management needs of modern-day investors. While futures do come with risk (and hence may not be suitable for all investors), they also offer benefits whose seeds could be worth sowing.

For more information on the foreign exchange markets, visit our currency ETFs category.