Futures Being used by a Fund Manager: Hedging

Futures can provide effective insurance against a major decline in the value of an investment portfolio, a form of hedging.

Consider the investment manager of a large Canadian diversified common equity mutual fund.

Assume that the manager is very concerned that the stock market as a whole might fall over the next few months. She knows that it would be very expensive to sell all of the shares in the fund but she still wants protection against a potential price decline. What she could do is hedge the value of her fund by shorting (i.e., contracting to sell) contracts consisting of the basket of stocks making up the S&P/TSX 60 index. By contracting to sell at some future date but at today’s prices, the manager will lock in the value of the fund. If the market does fall, then the value of her futures contracts will rise, thereby neutralizing the loss on the mutual fund’s stock portfolio. This is how derivatives are used by mutual funds managers to hedge portfolios against market declines. However, if the market should unexpectedly rise, then the value of the mutual fund’s stock portfolio will rise, but the value of the futures contracts on the index will fall.

Often, hedging limits not only losses but also gains. This is why mutual funds managers must be extremely careful when hedging their portfolios.

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