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October 12, 2016 - Should You Use Mutual Funds to Invest in Commodity Futures?
Mutual Funds That Use Futures by The Street
How and why you might -- and might not -- want to invest in a fund that uses futures.
So you' d like to try some of the risk-management and return-boosting strategies of people like Ken Griffin, 2015's top-earning hedge fund manager as head of Citadel Investments. But you're not knowledgeable about or comfortable with sophisticated investment tools like futures. It turns out you can still invest in a mutual fund or exchange-traded fund that employs futures in some of the same ways that hedge fund managers do.
Most funds do not use futures. Fund prospectuses typically rule out use of futures as well as other derivatives. They usually describe investment strategies that involve only buying and selling stocks and bonds.
Futures are, however, commonly employed in some types of funds. Some bond funds will use futures to hedge against changes in interest rates. Certain equities funds may employ futures to generate leverage in expectation of increasing returns beyond what a cash-only position could provide.
Commodities funds are the type of funds that most commonly use futures. Commodities funds employ futures contracts as an alternative to actually owning and taking possession of oil, livestock, precious metals or other commodities.
"Funds targeted towards these asset types use futures as it is often difficult to acquire, trade and store these physical commodities," explains Drew Jackson, president of Concorde Asset Management in Livonia, Mich.
REX Shares takes a different approach with a pair of recently created exchange-traded funds that hedge investments in stock indexes by investing in gold futures. The technique allows investors to invest long-term in equities, while diversifying with gold, which tends to not track moves in the stock market.
"We do it as potentially a more efficient way to get exposure to gold," says REX CEO Greg King. "We see investors who are looking for a solution that gives them exposure to gold but also allows them to maintain exposure to stocks."
Investors who want that combination can purchase shares in REX ETFs and let a team of professional investors handle details of the futures contracts. "It's all packaged up in one investment and gives the entire exposure all at once," King says. "It's a convenience factor."
King says financial advisors have shown good interest in the EFTs, but that individual investors have been less interested. "We don't spend too much time speaking to retail investors directly," he says.
Advisors often recommend against individual investors using futures or funds that employ futures. Barbara Delaney, founder of StoneStreet Advisor Group in Pearl River, New York, says they employ futures only for institutional clients, such as pension funds. "Within the context of 401(k) plans we manage, none of our funds use futures," she says.
Advisors often recommend against individuals using futures and funds that use futures because of the potentially higher costs, volatility and complexity compared to conventional long-only strategies. "It's a complex strategy that is typically used on an institutional level," Delaney says.
Ric Edelman, Chairman and CEO of Edelman Financial Services in Fairfax, Va., agrees that individual investors should avoid futures and funds that use them. "The fact that you can do certain trading strategies is a very different thing than saying that you should," Edelman says. "In my opinion, there's no justification for options or futures contracts to be used by mutual funds."
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What Are Futures?
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset their position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
According to Jim Rogers, "commodities get no respect." Here are a few reasons why he thinks they should: they are easier to comprehend and study than stocks and behave more rationally since they are subject to the basic laws of supply and demand; they have outperformed many other investment options in recent years; it is foolish to ignore an entire sector of the marketplace; and a bull market is currently under way in commodities--a trend that Rogers expects to last for a least a decade longer. Further, Rogers believes that you cannot be a successful investor in stocks, bonds, or currencies without an understanding of commodities. Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market is designed to introduce the novice to the basics of investing in commodities as well as explain what they are and why they are important. In doing so, he shatters some myths about the relative risks of commodities, explains the relationship between the stock and commodities markets, and provides a succinct analysis and history of the global oil, gold, lead, sugar, and coffee markets.
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