If an average investor were asked what a futures contract is, he or she would probably answer, “I am not really sure, but it sounds complicated and probably doesn’t impact me.” Futures contracts are agreements to buy or sell a specific item, in a specific quantity, of a defined quality, at a set price at a defined future date. The truth is that the futures industry affects many peoples’ daily lives and a form of futures contract is frequently used in several familiar activities.
For example, consider a typical transaction on Amazon®, during which the buyer pays a set price for an item or items to be delivered in a specific number of days. While this is an example of a modern day futures contract, it’s important to look at where and when this industry got its start.
The Creation of Futures Contracts
In the 1840s, Chicago had become a commercial center with railroad and telegraph lines connecting the middle of the country with the East. Around this same time, the McCormick reaper, a mechanical tool used to cut and gather crops, was invented, which eventually lead to increased wheat production. Midwest farmers came to Chicago to sell their wheat to dealers who, in turn, shipped it all over the country.
In 1848, The Chicago Board of Trade was created as a central place for farmers (sellers) and dealers (buyers) to meet and deal in “spot” grain – that is, to exchange cash for the immediate delivery of wheat.
The futures contract, as we know it today, evolved as farmers and dealers began to make commitments for future exchanges of grain for cash. For instance, the farmer would agree with the dealer on a price for 5,000 bushels of wheat at the end of June. The bargain suited both parties. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance. On occasion, the two parties may have exchanged a written contract to this effect and even a small amount of money representing a guarantee. We now refer to this as “margin” for an account, which demonstrates commitment to a position.
Such contracts became common, and were even used as collateral for bank loans. They also began to change hands before the physical delivery date. If the dealer decided he didn’t want the wheat, he would sell the contract to someone who did. Or, the farmer who didn’t want to deliver his wheat might pass his obligation on to another farmer. The price would go up and down depending on what was happening in the wheat market. If bad weather came, the people who had contracted to sell wheat would hold more valuable contracts because the supply would be lower. If the harvests were bigger than expected, the farmer’s contract would become less valuable. It wasn’t long before people who had no intention of ever buying or selling the actual wheat began trading only the contracts. This brought about the first futures speculators, hoping to buy low and sell high, or sell high and buy low. During this time, futures contracts began to be standardized. For instance, contracts now would specify the quantity of the contract, quality of goods (a specific grade of the commodity) and time and location of delivery (should the buyer accept delivery). This left only the price of the contract to be determined.
The Evolution of Futures Contracts
Futures contracts have evolved quite a bit over the past 150+ years. Initially, futures markets only included a few commodities, mostly wheat, corn and soybeans. It quickly evolved to allow investors to hedge, or speculate, on not only the world’s major commodities, but also the world’s major indices, debt products and currencies. As more futures markets were created, this attracted additional speculators to use the futures market as a way to make bets on the rise or fall of a specific market. Today, there are over twice as many futures contracts traded daily as there are shares of stock traded across every U.S. stock market combined. Stock market volume equals approximately 5 million shares traded daily, while the overall futures market averages 11 million contracts*. In 2015, the overall futures market volume was over 24 billion contracts annually** with a value over $11 trillion annually.
The history above leaves out many major developments, such as the shift to electronic trading from the open outcry method of trading that made the commodity “pits” so legendary. Another major advancement that is necessary to highlight occurred on October 24,1974, the date that Congress passed the Commodity Futures Trading Commission Act of 1974.The bill overhauled the Commodity Exchange Act (CEA) and created the Commodity Futures Trading Commission (CFTC or Commission), an independent agency with powers greater than those of its predecessor agency. The CFTC remains the regulatory body today that oversees all commodity futures and options markets much like the Securities and Exchange Commission (SEC) does for the equity markets.
Managed Futures Strategies
This is the foundation needed to answer the question asked at the beginning of this article, What are Managed Futures? In the simplest of terms:
Managed futures are defined strategies traded by professional money managers, known as commodity trading advisors (CTAs), on behalf of investors. Managers invest in energy, agriculture and currency markets (among many others) using futures contracts and determine their positions based on expected potential profit and warranted risk.
The CME Group, the world’s leading and most diverse derivatives marketplace, elaborates:
“Managed Futures are a diverse subset of active hedge fund strategies that trade liquid, transparent, centrally-cleared exchange-traded products, and deep interbank foreign exchange markets. Managers in this sector are called Commodity Trading Advisors (CTAs). This name goes back to the origin of the strategy when, unlike today, most CTA activity was in commodities. Currently, their strategies are also largely focused on financial futures markets — equity indices, fixed income, and foreign exchange — with additional allocations to energy, metals, and agricultural markets. There are also Commodity Specialist Managers that focus mainly or exclusively on commodity markets. They may further specialize in one or more asset classes within the commodity space, such as energy or agricultural.”
Managed futures first rose in popularity in the 1970s with the introduction of trend followers and became compelling to investors due to their low correlation to the stock market and their ability to create “crisis alpha.” The predominant strategy remains trend following, but this approach has evolved significantly in sophistication in recent years, and the overall space has become increasingly diverse.
In general, trend followers aim to identify and exploit sustained capital flows across asset classes as markets move out of and into equilibrium, often after prolonged imbalances. Other CTA styles thrive on volatility and choppy price action that accompanies these flows, as well as a variety of other market phenomena. The number and variety of programs has risen sharply with the advances in trading technology, data analysis, and increased interest from quantitative traders in establishing their own trading firms. Methodology of the trading firm is typically routed around fundamental, technical strategies or a combination of the two, but how these strategies are executed varies widely by trading firm. Strategies can vary between systematic, discretionary, spread, arbitrage, value, option, sector specific, and diversified or some sort of combination between these.
As of the end of 2015, managed futures had a total of approximately $334 Billion** in client capital being traded across these strategies. Total assets have more than doubled over the past several years, and continue to grow. Much of this growth happened in response to the panic of 2008 when this asset class was one of the few winners. There is a substantial body of research that has shown in a very clear and concise way that over the long term, managed futures can lower overall portfolio volatility and increase overall return. The ability to be both dynamically long and short creates the opportunity to profit from various market environments. That is not to say that managed futures always make money. Clearly that is not the case. It is however to say that managed futures should be considered as a potential building block of any balanced portfolio, due to their ability to provide a non-correlated investment, reduce portfolio volatility and enhance returns.
For illustrative purposes only.
p.a. – per annum
Stocks are represented by the S&P 500. The S&P 500 stands for the Standard and Poor 500. It is a stock market index that tracks the 500 most widely held stocks on the New York Stock Exchange or NASDAQ. It seeks to represent the entire stock market by reflecting the risk and return of all large cap companies.
Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.
Managed futures: The CISDM Fund of Fund index and the eight individual CISDM Hedge Fund Strategy Indices reflect the median performance of funds within self-reported fund of fund and hedge fund strategy classifications reporting to the Morningstar CISDM Hedge Fund Database. In addition, the CISDM Equal Weighted Hedge Fund Index and CISDM CTA Equal Weighted Index reflect average performance of all hedge funds and CTAs reporting to the database, respectively.
The calculations of the CISDM Equal Weighted Hedge Fund Index and CISDM CTA Equal Weighted Index average index performance does not include outliers which are at least +/-3 standard deviation away from the average. In the calculations of the eight individual CISDM Hedge Fund Strategy Indices, the CISDM Funds of Funds Diversified Index and the CISDM Equal Weighted CTA Index, duplicate funds (e.g., fund that differ only in currency) have been eliminated.
Alternative investment products, including hedge funds and managed futures, involve a high degree of risk. Alternative investment products can be volatile. An investor could lose all or a substantial amount of his or her investment.