Are Futures in Your Investing Future? Maybe They Should Be

The futures market isn't always for the faint of heart, but it can be a great source of diversity for a portfolio.
By Eric Reed ,

Futures are a poorly understood segment of the market. At their most basic, these contracts are purchases against performance. You buy a commodity on the belief that prices will go up or purchase an ownership stake in a contract on the belief that it will get more valuable.

So, for example, I can purchase ten tons of coffee bean futures on the belief that next week they'll cost a little more than they do today, and I can flip my Arabica for a profit.

Few individual investors succeed in the futures market. It requires highly specialized knowledge (consider, for example, everything that could nudge the price of a coffee bean) and generally takes a big pot of money to participate in the first place. Don't be scared completely off though, because there can be room for this product in the average portfolio.

You just have to plan carefully.

First, said John Schindler, with UBS's Peninsula Wealth Management Group, don't look to buying individual futures products. Instead, look into a managed futures account.

In a nutshell, MFAs are to futures what mutual funds are to stocks: a way of lowering the risks and barriers to entry by bundling individual contracts together into a packaged financial product. Rather than having to know everything about coffee beans or oil markets, you can buy into a portfolio with assets in each of those products.

"We don't advise clients to buy specific futures contracts," Schindler said. "We tell clients to think about and look at the managed futures of an allocation, no different than stocks or bonds within a portfolio."

These contracts can invest in one of five categories: stock indexes, bonds, interest rates, currencies and commodities. So one might specialize in currencies, investing in the exchange rates of a dozen monetary systems around the world, while another might package together 15 different types of agricultural products. The result is something far less prone to shockwaves, but still potentially valuable to the average investor.

The reason is that same golden word when it comes to investing: diversity.

"It can be completely uncorrelated to stocks," Schindler explained.

"The big benefit that we see is the diversification and the benefits to an overall portfolio, because it allows you to see a more active rebalance," he said. "I like to tell investors, in 2008 when the stock markets declined dramatically that was one of the best years in recent record for managed futures. That allowed clients who had that as a sleeve of their diversification to take profits from those managed futures and buy into things that were down dramatically."

One of the biggest flaws with many investment portfolios is a reliance, even an over-reliance, on stocks and associated mutual funds. That can be fine most of the time, but during overall market downturns, it can leave even a seemingly well-diversified portfolio vulnerable. Whether or not you spread investments over multiple industries, they still all participate in the same basic stock market and can be hit by many of the same trends.

Far less so for futures. Since these don't trade the same product (ownership of companies, in the case of stocks, as opposed to ownership of specific goods in the case of the futures exchange), they often don't play by the same rules. Indeed, the two markets can often run counter-cyclically to each other, with commodities becoming more valuable as faith in business declines.

"Managed futures can benefit from prices going in either direction," Schindler said. "Historically, they have been either negatively correlated or had a very low correlation to stocks and bonds, and so they have been a wonderful diversifier to a broadly diversified portfolio."

The other benefit that managed futures add are their tendency to thrive during volatility.

Futures markets are far more prone to short selling and speculation than stocks and bonds, so investors are often as likely to profit when prices drop as when they rise. The result is that an MFA really makes its money during protracted swings in value.

"They're looking to benefit from sustained large moves up or down," Schindler said, but critically a well-run MFA can benefit from either.

That's not the case for an average investment portfolio.

For most individuals who have money in the stock market, reliability is the name of the game. Few people can move quickly or accurately enough to keep up with a volatile market, and short-selling is far less common, so portfolios almost inevitably lose money once prices start to fluctuate.

MFAs can be a way to protect your portfolio against that, by building in assets that can benefit while the rest of your investments suffer. Of course, that comes with the knowledge that these products often require unpredictability to make any money.

"It depends on a person's risk tolerance," Schindler said, "and this certainly in my view is not appropriate for somebody who is conservative. In general, managed futures will do better during periods of volatility. When there is not much volatility they tend not to do as well."

For his clients, Schindler recommends an asset balance of three to eight percent of the portfolio, "depending on how conservative or aggressive a client is."

It's an amount calculated to allow clients to take advantage of the counter-cylical nature of the futures market, while not overly investing in something not built for the average investor.

This product may not be for the faint of heart, and sinking your money into next month's crop will probably end badly, but the futures market can have a lot of value if you use it right.

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