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
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.
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
Futures’ flexibility and liquidity
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.