What Is a Futures ETF and How Does It Work?

Exchange-Traded Funds (ETFs) are widely used investment tools that offer exposure to various assets through a single security trading on stock exchanges. While many ETFs hold traditional investments like stocks or bonds, some employ more complex financial instruments. This article explains what a futures ETF is, how it functions, and its distinct characteristics.

What Defines a Futures ETF

A futures ETF is an exchange-traded fund that primarily invests in futures contracts, not physical assets or traditional securities. This structure allows the fund to track the price movements of an underlying commodity or financial instrument without the logistical challenges of storing or managing the actual asset. The fund’s value is derived from the performance of these futures contracts.

An ETF represents a basket of underlying assets, with shares trading on stock exchanges throughout the day, much like individual stocks, providing investors with liquidity. A futures contract is a standardized legal agreement to buy or sell a specific commodity or financial instrument at a predetermined price on a specified future date.

The distinction between a futures ETF and a “physical” ETF lies in their underlying holdings. For example, a physical gold ETF holds actual gold bullion, aiming to mirror the spot price. In contrast, a gold futures ETF invests in futures contracts tied to gold’s price, meaning its performance is tied to the gold futures market, which can differ from the immediate spot market price.

Operational Mechanics of Futures ETFs

Futures ETFs track price movements by holding and managing a portfolio of futures contracts, rather than owning the physical asset. The fund manager continuously adjusts the portfolio by buying and selling these contracts. This approach enables the ETF to provide exposure to a wide range of markets, including commodities, currencies, and volatility indexes.

A key aspect of managing a futures ETF is “rolling” futures contracts. Futures contracts have defined expiration dates. To maintain continuous exposure, the ETF manager sells expiring contracts and purchases new ones with later expiration dates. This process is performed regularly, often monthly, to ensure the fund holds active contracts.

Market conditions like contango and backwardation significantly impact futures ETF performance, especially during rolling. Contango occurs when the price of a future contract is higher than the current spot price, or when longer-dated futures contracts are more expensive than nearer-dated ones. If an ETF rolls contracts in a contango market, it sells lower-priced expiring contracts and buys higher-priced new contracts, which can lead to a drag on performance over time.

Conversely, backwardation describes a market where longer-dated futures contracts are cheaper than nearer-dated ones. In a backwardated market, rolling contracts can potentially benefit the ETF, as the manager sells higher-priced expiring contracts and buys lower-priced new contracts. However, these market conditions fluctuate, and contango is often more prevalent in many commodity markets. The repeated costs associated with rolling contracts in contango can cause the ETF’s performance to diverge from the underlying asset’s spot price.

Futures ETFs often have higher expense ratios compared to traditional ETFs. This is due to the active management required for rolling contracts and managing complex futures positions. These higher operating costs reduce the net return to investors.

Types and Characteristics of Futures ETFs

Futures ETFs track a variety of underlying assets, providing exposure to different market segments. Commodity Futures ETFs are common, tracking assets such as crude oil, natural gas, precious metals, and agricultural products. These funds aim to replicate the price movements of the specific commodity futures market.

Currency Futures ETFs allow exposure to the value of one currency against another, such as the Euro versus the U.S. Dollar. This can be used to speculate on currency movements or to hedge against foreign exchange rate fluctuations. Volatility Futures ETFs track futures contracts based on market volatility indexes, such as the CBOE Volatility Index (VIX), providing a way to invest in anticipated market turbulence.

Futures ETFs’ liquidity is influenced by the ETF’s trading volume and the liquidity of the underlying futures market. If futures contracts are not actively traded, it can impact the ETF’s ability to execute trades efficiently and at desired prices. The depth and activity within the specific futures market affect the ETF’s operational fluidity.

Due to their structure, futures ETFs are often subject to different tax treatment compared to traditional equity or bond ETFs. Gains and losses from futures contracts held by these funds are subject to Section 1256 of the Internal Revenue Code. This provision stipulates that 60% of any gain or loss is treated as long-term capital gain or loss, while the remaining 40% is treated as short-term capital gain or loss, regardless of the actual holding period. This distinct tax rule can influence after-tax returns for investors.

Tracking error is inherent to futures ETFs, indicating the degree to which the ETF’s performance deviates from its underlying index or asset’s spot price. Factors such as rolling costs, contango or backwardation effects, and the fund’s expense ratio contribute to this tracking error. These operational realities mean that while a futures ETF aims to follow the price of its underlying asset, perfect correlation is rarely achieved over extended periods.