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Theory lesson

I have been talking to an adviser about my investment portfolio. He has mentioned forwards, futures and options and, in particular, a managed futures fund. Can you explain the difference between these products and how any of them might be of benefit to me?

Forward contracts are the principal risk management tool for the great majority of businesses. In basic terms, a forward contract is simply a commitment made today to conduct business on specified terms at some time in the future.

A forward contract is an over-the-counter agreement made between two parties for the purchase or sale of a specific asset or commodity at the current price but with delivery and settlement at a future date. As such, it is a financial derivative in the form of a tailor-made contract that is not traded on an organised exchange where the counterparties agree to exchange a specific asset for a fixed price at a future date.

A futures contract is almost identical to a forward contract but with some important differences.

A futures contract is the purchase or sale of a standard quantity or quality of a specific asset or commodity at a specified price on a future date. As such, it is a financial derivative in the form of a standard transferable agreement where the counterparties agree to exchange a commodity or financial asset for a fixed price at a future date.

The main differences are that:

  • Futures are traded on regulated exchanges while forward contracts are not.

  • Settlement takes place periodically, typically daily, against the current market price of the underlying product whereas forward contracts remain unsettled until delivery has taken place. This simplifies the handling of the forward contract but it also increases the counterparty risk.

    Options are financial instruments that convey the right but not the obligation to engage in a future transaction to buy or sell an underlying security.

    For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration while buying a put option provides the right to sell. The option holder’s decision to exercise the option means that the party who sold or wrote the option must fulfil the terms of the contract.

    Managed futures describes an industry comprising professional money managers who run assets on behalf of their clients. Using the global futures markets, they implement their systems to take positions based on expected profit potential.

    Managed futures investments have been used by individual investors for more than 26 years. More recently, institutional investors such as pension funds have incorporated managed futures as part of a well diversified portfolio.

    As an asset class, managed futures are increasingly being recognised as an important investment alternative that may potentially enhance returns and lower the overall volatility of a diversified investment portfolio.

    Today, a variety of academic research and evidence demonstrates the potential benefit of incorporating managed futures to create better balance in an equity and bond portfolio.

    Futures investments involve substantial risk and are not suitable for everyone but the general conclusion is that diversification of non-correlated asset classes, such as the introduction of a managed futures fund into an investment portfolio, can reduce portfolio risk and enhance overall portfolio performance.

    Modern portfolio theory was introduced by economist Harry Markowitz in his paper Portfolio Selection published in 1952.

    In 1990, Markowitz, with William F Sharpe, and Merton H Miller, won the Nobel Prize for their contributions to financial economics. In fact, their contributions were what started financial economics as a separate field of study.

    The concept of modern portfolio theory was further advanced by the work of Harvard professor Dr John Lintner in his 1983 study, The potential role of managed commodity – financial futures accounts in portfolios of stocks and bonds.

    He stated: “The combined portfolios of stocks (or stocks and bonds) after including judicious investments in appropriately selected sub-portfolios of investments in managed futures accounts … show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone.”

    If you accept the basic premise of modern portfolio theory that combining various securities which display low or non-correlation can improve the risk/return metrics of a portfolio, it can be argued that adding an additional asset class such as managed futures can be beneficial to your investment portfolio.

    Patrick Murphy is director of wealth management at Thinc

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