Many years ago, Barron's published an article I wrote called
"Your Advantage in Alternative Investments." The following is almost quoted:
"History teaches us that performance and movement of futures and options on futures greatly differ from traditional investments during various market cycles and do not track well. The question investors must ask when they survey available capital management vehicles is:
How can prudent allocation among investments utilize these discrepancies to my financial advantage?
To fully understand market movements within futures and options on futures, it is necessary to step outside conventional thought and reach towards something more direct, adaptable, liquid and potentially lucrative. The price protection of the futures markets have evolved from basic foods to encompass our entire financial system including interest rates, stock indices, bonds, currencies, and oil. Each and every futures market was conceived to hedge inherent risk in the contracts' cash market equivalent. Every cash market is essential to material survival.
What is a hedge?
A real hedge defines a company’s long (buy) or short (sell) cash market needs and uses the futures and options market to "lock in and stabilize" cash market prices so business commitments, profits and long term economic stability can be built and maintained. The futures contract (derivative) is only used to stabilize the cash market.
A Company that hedges always uses equal futures and options to meet their cash market need. The transaction is complete only when both cash and futures positions are offset or liquidated.
We liquidate the futures/ options contracts by making or taking cash delivery against our position, or by taking the opposite side at the same time that our cash market position is liquidated. A true hedge always has four legs or transactions and always includes the cash market. Profits are alway quantified and limited when hedging. We sacrifice unlimited upside potential for stability and no risk.
+ Long (buy) Cash - Short (sell) Futures
- Sell Cash + Buy Back Futures
Hedging stabilizes prices of commodities that meet our daily needs such as: coffee, sugar, breakfast cereal, bread, gas for our car, money (interest rates), mutual fund returns and even the shirt on our back; so remember to say thank you once in a while!
Hedge Funds "Truth" and Hedging
Hedge funds were created in the 1980’s as an investment category because of jealousy. Investment advisors were obsessed that commodity advisors were allowed incentive fees. To keep everybody happy someone said OK here’s a category for investment advisors, we'll call it hedge funds.
A hedge fund has nothing to do with hedging!
A hedge fund has nothing to do with real hedging, and never will. People appropriated the term "hedging" from futures where it originated, because it can be trusted. Just like real hedging can be trusted. Hedging is why futures exist. Any other application of futures and options on futures is a by-product or indirect application. Just like a cow, you get grades of steak and chop meat. The steak is pure. The chop meat has more risk because you never know what’s in it! The term or application of hedging originated in futures over 170 years ago. The language and truth of hedging used by hedge funds is indirect and misleading.
Hedge funds allow investment advisors to legally charge incentive fees, like commodity trading advisors receive. A hedge fund is one category of alternative investment. Its' business structure is exempt from registration. Its’ investment category is directly related to whatever skills the sponsor or general partner have. Since hedge funds evolved from the securities industry most specialize in equity related strategies. If involved in futures, they are required to register with the CFTC and NFA as commodity pools, or file a legal exemption.
Common Sense and Risk Management
We now understand that hedging is used to manage cash market risk and serves a valuable economic purpose.
Investment strategies can intelligently be used to offset inherent market risk within other investment strategies. However investment strategies are not hedging. As a standalone system used for investment, stocks, bonds, real estate derivatives and all related options would not exist and serve no fundamental economic purpose!
Back to the Barron's article:
" Compared to more traditional investments, which are usually held for one year or longer futures offer a unique TIME VALUE USE OF CAPITAL totally unique to investments. Positions within the portfolio may be held for one hour to six or nine months. The condensed time frame enables investors to capitalize on the market’s volatility and shorter-term trends to seek long term capital appreciation. This ability to integrate an investment with TIME VALUE USE OF CAPITAL so distinctive gives you the opportunity to incorporate a "Yield Curve Effect" into your entire portfolio.
Extending this concept into the entire universe of investments enables the futures and options markets to be an alternative investment to comfortably reduce the risk of both traditional and other alternative investments including hedge funds. Direct access to total liquidity and the short side of a market allows risk associated with equities to be translated into potentially substantial profits.
Stock and mutual fund managers switch positions only from long to cash during anticipated trend changes. In futures and options on futures, managers have choices of offsetting risk of futures with options, using spread strategies, going from long to short or combining variable strategies using options and futures that reduce risk without eliminating upside potential
When superior use of leverage and time related to money is used, managed futures can offer the comfort of lower volatility under most market circumstances