Harbor Crest Wealth Advisors founder and CEO Mike Hennessy spoke with U.S. News & World Report about derivatives and whether you should invest in them.
Derivatives are financial instruments that "derive" their value from an underlying asset. That underlying asset can be stocks, bonds, currencies, commodities, and even market indices. "A derivative, at its essence, is simply a contract between two parties" detailing the cost and rules for the exchange of goods or money at a future date, Hennessy told U.S. News & World Report.
To explain how financial derivatives work, Hennessy uses the example of a corn farmer. Imagine that your family's financial future rides on the sale of the corn you harvest. You have a pretty good idea of how much corn you'll have available at harvest time. But what if at the exact moment you go to sell, the price of corn drops sharply? This is a massive financial risk for you and your family.
If you thought corn prices might drop in the future but were at a good price today, you might want to lock in today's price for your future crop of corn. This is precisely what derivatives can do. "You could enter into a contract with another party to sell your future corn harvest using current market pricing," Hennessy said. "The buyer gets what he or she wants — buying corn in the future at today's pricing — and you get what you want — selling corn in the future at today's pricing."
Derivatives aren't inherently good or evil, and given this, there isn't a real reason to seek out or shun funds that deploy derivatives. "All that said, due diligence on your part as an investor is crucially important," Hennessy said. "Knowing, or asking, how fund managers use derivatives in their investment process, how they manage the risk of the derivatives and how much of the fund is dedicated to derivative exposure is paramount."