Hedge risk, access new markets, adjust exposure: What futures can offer experienced investors

LONG-TERM investing has become more demanding in an uncertain economic environment. A market downturn, a move in gold or interest rates or developments overseas can all affect your portfolio.

You may be comfortable holding a portfolio of equities for years, but still want to manage your exposure ahead of an election, central-bank decision or major economic announcement. You may also want exposure to commodities, interest rates or overseas markets without buying the underlying assets directly.

Futures can offer a way to manage that exposure and respond to market movements without necessarily selling your existing holdings. They can also provide access to asset classes beyond stocks.

But they come with leverage, which means losses can build quickly if the market moves against you. The key is understanding how they work, what risks they carry and why you are using them. Here are three practical use cases to consider.

Hedging against a market downturn

Managing short-term market risk is one of the clearest examples of how futures can complement an existing portfolio, says Ken Ong, chief executive officer of brokerage firm KGI Securities (Singapore).

“An investor with a large equity portfolio can use index futures to reduce downside exposure ahead of an uncertain event, without having to sell holdings and trigger costs,” he explains. The same principle can apply to other exposures, such as currencies or commodities.

Consider, for example, a $1 million portfolio of Singapore-listed equities that you want to hold for the long term but are concerned about a potential near-term market correction.

Rather than selling a large portion of your portfolio, you could take a short position in an appropriate equity-index futures contract. If the broader market subsequently falls, gains on the futures position could partially offset losses on your equity portfolio.

The reverse is also true. If the market rises, the short futures position could lose money while your underlying portfolio gains.

And the hedge will rarely be perfect. The stocks in your portfolio may not move in exactly the same way as the index represented by the futures contract. This is known as basis risk. The size of the futures position also matters: if you hedge too little, you may still have substantial downside exposure, while hedging too much could create unnecessary losses if markets rise.

There are also margin requirements to consider. Futures positions are regularly adjusted to reflect market movements. If the trade moves against you, you may need to add more funds to your account to meet margin requirements. You therefore need sufficient liquidity to maintain the position even if the hedge is ultimately intended to offset losses elsewhere in the portfolio.

Gaining exposure beyond stocks

Futures can also give you access to markets that may be less straightforward to access through conventional equity investments.

“They open access to asset classes that are otherwise hard to reach directly, such as energy, metals, agriculture and interest rates,” says Ong.

For example, if you think gold prices could rise, you could trade a gold futures contract rather than buying physical gold. Futures can also provide a more practical way to gain exposure to markets such as crude oil or agricultural commodities, where buying and storing the underlying asset directly would be difficult. You can also use futures to take a view on interest-rate movements without holding the underlying debt instruments.

But exposure to a different asset class also means exposure to different market drivers. For instance, oil prices can respond to supply decisions, inventories and geopolitical developments, while agricultural commodities may be affected by weather and crop conditions. Interest-rate futures, meanwhile, can move in response to inflation data, central-bank policy and expectations for where interest rates are headed.

So it is important to understand what could move the market and how the futures contract itself works. This includes contract size, expiry date, settlement method and liquidity.

Leverage adds another layer of risk. You typically need to post margin that represents only a portion of a futures contract’s full value. But gains and losses are based on the contract’s full exposure, so even a relatively small market move can translate into a much larger gain or loss relative to the amount you initially put up.

Flexibility in adjusting market exposure

Markets can move quickly in response to an economic announcement, geopolitical development or overseas market move. Futures can give you greater flexibility to adjust your market exposure without having to buy or sell the underlying stocks or ETFs immediately.

For example, you may expect a major US inflation reading or Federal Reserve decision to trigger volatility in global markets. Singapore’s stock market may be closed when the US data is released, but relevant overseas futures markets may still be trading.

This flexibility can be useful, but it comes with trade-offs. Around major announcements, futures prices can move quickly and trading conditions can change. As a result, you may not always be able to trade at the price you expect. There is also the risk of holding a position longer than intended. Futures have expiry dates, so if you want to maintain the same market exposure beyond that date, you may need to close the expiring contract and open a new one with a later expiry. This is a process known as rolling the position, and the price difference between the two contracts can affect your returns.

The appeal of futures lies in that flexibility. But flexibility on its own is not a reason to use them.

Futures are not a replacement for stocks or ETFs. Instead, they can give you another way to manage exposure, access different markets and respond to developments as they happen. As Ong notes: “Used well, futures are a portfolio management tool, not just a trading instrument.”

Whether they belong in your portfolio still depends on what you are trying to achieve, how well you understand the contracts and how much risk you are prepared to take.

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Disclaimer:

This content is for informational purposes only and does not constitute investment advice or an offer, solicitation, or recommendation to buy or sell any securities or financial instruments. It does not take into account your personal investment objectives, financial situation, or holdings. KGI Crusoe (KG Securities (Singapore) Pte. Ltd.) makes no representation and assumes no liability for the accuracy or completeness of this information, or for any loss arising from its use.

Investments involve risk of loss. Please exercise caution when making investment decisions. This advertisement has not been reviewed by the Monetary Authority of Singapore.