For anyone who is an investor or participant in the stock market, outperforming the market is the key goal at the start of every year. In fact, beating the market returns is what separates average investors from successful ones. Over the last thirty years, money managers have shifted from picking individual stocks to index funds to match or slightly outperform the market rather than attempt to completely obliterate the market returns.
Index funds are a basket of stocks grouped together designed to match the overall market. Instead of attempting to pick individual stocks of firms you believe will outperform the market, index funds capture a wide variety of stocks to mirror the market performance. Index funds help investors hedge against negative events and downsides that could threatening an entire portfolio of stocks.
One specific type of index funds are the futures, which have quickly become a favorite among investors. Futures contracts of stocks are like those as commodities as only the settlement differs. In a futures contract, investors bet on the future direction of all the stocks in an index. If investors believe stocks are generally going higher, then they’ll buy the futures and collect cash from the gain on settlement. Likewise, if investors feel the market for stocks will be more bearish, then they can short the futures and collect cash from the profit they made when covering their shorts.
Futures offer portfolio managers another risk tool to hedge against catastrophic market events. Instead of trying to swiftly sell individual stocks at unfavorable positions, portfolio managers can instead use futures contracts to hedge against the downside and avoid any further losses. In addition, if an investor wants broad exposure to the market rather than purchase many different individual stocks of firms in various industries, an index fund also fits the purpose.
One example of a fund that trades in futures and can have a powerful influence on the market is the S&P 500. The S&P 500 is considered the benchmark index of the market due to its broad representation and scope. If the S&P 500 futures are bullish, then this typically spills over into the market and pushes stock prices generally higher. However, if the S&P 500 futures are bearish, this volume of sellers can create panic in the market and cause swift declines in stock prices. One example recently of S&P 500 futures plummeting in value and spilling over to the market was the Flash Crash of 2010.
Finally, index futures allow traders to make transactions that are highly leveraged. Leverage allows investors to purchase more futures contracts on a loan rather than cash straight up. Although leverage can assist investors in creating large profit spreads, it can also create market distress if their leveraged futures contract backfires and they are unable to repay the loan. This action can also spillover into the market and cause short-term turmoil on market prices.
Index futures assist portfolio managers in hedging against events that can create havoc for a portfolio of individual stocks. However, with the popularity of index futures continuing to rise and the high leverage utilized to conduct these transactions, index futures can create adverse market environments for ordinary retail investors.
