Issue: September/October 2005

Derivatives Part 2 - Back to the Futures

The mere mention of the word "derivative" is sure to send a shiver down most trustees' spines. The mathematical mystique surrounding derivatives has led to them being misunderstood, and even feared. But the effective, responsible use of derivatives can be a powerful tool in enhancing and protecting the value of one's portfolio. In fact, derivatives were invented for just that purpose - risk management.

There are essentially two types of derivatives: options and futures. Our previous article focused on the nature and use of options. This article will address the nature and use of futures.

What is a Future?

Simply put, a futures contract is an agreement to buy or sell an asset at a future date at a specific price through an exchange. It differs from an option in that both parties are contractually bound, no matter what happens to the underlying asset price over the course of the contract.

These contracts are priced daily as the ruling price of the underlying asset is reflected or "marked to market." To obtain a future, a margin of approximately 8% needs to be deposited at SAFEX (The South African Futures Exchange).

A future is often best understood as an extension of the buy-on-credit society we live in. Just like we buy clothing on our credit cards, which we pay for later, a future can give us exposure to the equity market now, which we pay for later.

Why use Futures?

  • The purchaser of a future is effectively acquiring an underlying asset without having to pay the full amount upfront. This can increase returns relative to the amount invested (but can also increase the potential risk).
  • Liquidity: The liquidity in the index futures market (like an ALSI40 future) is far higher than the liquidity of the individual stocks in the index. This enables portfolios to rapidly implement or change a view, and then later unwind the futures as they are replaced with actual physical equity exposure. This is particularly useful when making changes to asset allocation, such as reducing or increasing equity.
  • Futures also allow investors to hedge the risks of adverse price movements in the market. To illustrate: Assume a portfolio has a mandate to track the performance of the equity market (otherwise known as an index tracking fund). Should the portfolio receive a large cash inflow it will obviously be invested in the equity market as quickly as possible, but the portfolio is exposed to the risk that the equity markets will run whilst in the process of investing the cash. By buying a future, the portfolio will get instant exposure to the equity markets.
  • The transaction costs of futures are lower than those of equities and thus a derivative strategy is often preferable to a physical one.
derivatives [diagram]

Risks and Rewards

The risk that always needs to be monitored with futures (or options for that matter) is gearing. In fact, in all of the derivative accidents that have happened historically, the use of gearing played a significant role.

Futures can buy more exposure per Rand than shares. To obtain a future, a margin of approximately 8% of the value of the future needs to be deposited at SAFEX. Therefore it is possible to buy or sell more exposure than the actual value of your investment, thus gearing your portfolio. To illustrate: Assume you have R8 000 to invest, and use the entire R8 000 as a margin for an equity future. This would give you R100 000 worth of exposure to the market. This means that the value of the market exposure is 12 times greater than the amount invested (R100 000 / R8 000). The market need only move 8% against you and you will have lost your entire R8 000. Should the market move even more, you will have to pay in additional amounts to cover the losses.

The responsible use of derivatives avoids gearing altogether. Thus, using the above example, the investor should only buy R8 000 worth of exposure with his capital. In this way, he cannot lose more money than he has. Responsible risk management would ensure that the futures exposure is matched 1:1 with the underlying equity. Asset managers do not need to use the gearing feature that derivatives provide to use futures effectively.

Importantly, futures should not be avoided just because of the potential gearing risks. Rather, these risks should be prudently managed so that the many benefits of futures can be exploited. Prudent portfolio management would ensure that futures are carefully implemented, and gearing should be avoided.

Essentially, derivatives (in the form of both futures and options) can be used as a "sweetener" to enhance returns or protect a portfolio from unforeseen market movements. They are also useful in portfolio construction for rapid and cost-effective implementation. The key is to ensure that derivatives are understood and responsibly implemented.

Derivatives should never be used as a speculative instrument in a portfolio, and the use of gearing should be avoided at all costs. But to avoid derivatives altogether due to their perceived riskiness might, in fact, introduce more risk into your portfolio. The risk does not lie in the derivative, but in the use of the derivative. Derivatives are a bit like medicine: properly applied, medicine can heal a sick patient; incorrectly applied, the same medicine can harm. As long as derivatives are used in a responsible way, they can enhance a portfolio's risk-adjusted performance.