Anytime I talk to investment committees or trustees about investment tools such as futures, options, or swaps the first question is “Aren’t those very risky?”. These tools collectively referred to as derivatives, create fear and sometimes loathing in the minds of those who can and should use them to meet their investment objectives. The D-word is a very bad word in some investment committees or among some board of trustees. This ain’t be so.
It is unfortunate that we investors do not have a better way to distinguish between an index futures contract and a Credit Default Obligation. We lump them all as derivatives and call them untouchables. It is like saying a diesel generator and a nuclear reactor pose the same risk to human health.
A derivative is something that derives its value from the value of an underlying asset. An index futures contract like the S&P 500 futures contract gets its value from the underlying S&P 500 index. The economic exposure of the S&P 500 futures contract along with the cash holding is very similar to the economic exposure of buying an S&P 500 index fund or an S&P 500 ETF with that cash. The difference between the two is that there is no cash outlay when you buy a futures contract (unlike when you buy a fund or ETF where you pay the cash to get the shares). Operationally the futures contract is marked to market daily, and thus any gain/loss is exchanged as collateral/margin with the clearing broker.
When the total value of the futures contract is not backed by an equivalent amount of cash then there is leverage. If the contract value is $1 million and we have only $100,000 in the account we are leveraged. This is where risk comes into the picture. We cannot buy a $1 million worth of S&P 500 ETF shares without $1 million in cash (unless buying on margin from a prime broker, which is leverage). We can easily buy a $1 million worth of S&P 500 futures contract with less than $100,000 in initial margin. So you need to hold the remaining $900,000 in cash somewhere to back the futures contract. Otherwise there is leverage and there is risk (besides equity risk). So a derivative such as an S&P 500 index futures contract can be as mundane as an index fund when properly backed by cash or could be the instrument of choice for a levered hedge fund to speculate on the directionality of the market with very little capital upfront. In the case of the hedge fund, if you are correct you win big (simply because of the mathematics of leverage) and if you are wrong your capital is wiped out (again simply because of the mathematics of leverage).
My wife, Holly, is a quilter and she uses some very sharp and scary looking tools. The rotary cutter, for example, could easily slice through my finger like knife through butter. She uses these tools to create beautiful, vividly colorful quilts that have special meaning for the person she is making these for. One could also use these tools to harm another person.
Investment tools such as “derivatives” are merely tools that we choose to use the way we see fit. Risks in these instruments come mostly from leverage. So how and why we use these instruments matter. What if we use futures to get market exposure to cash that is idle in our operational cash account. This cash may not be earning the equity return that you expect from your asset allocation simply because it is not invested or it is not possible to invest. Why not use the operational nature of futures (small cash outlay upfront) to get equity exposure while holding the equivalent amount of cash in your operating account as before. You get the market return (good or bad, as mandated by your investment policy) and you have the cash in your account, for operating needs. There is no leverage. This process is called Cash Overlay and is used by many institutional investors. A simple yet effective way to use derivatives for the right reason – to achieve the investment outcome you need.