Mutual funds typically invest in not traditional asset classes like stocks and fixed-income securities such as bonds. Some, however, also utilize derivatives contracts such as options and futures. These exist as a separate category of mutual funds that specialize in investing in derivative instruments that would fall under the more general category of a 'speciality fund' These funds may be an excellent investment tool for investors who wish to diversify their portfolios with options and futures for various companies' stocks and commodities. Note, however, that the use of derivatives can also increase the riskiness of the fund.

While most mutual funds out there do not use options and futures, many hedge funds do. Hedge funds, however, are often not available for ordinary investors whereas mutual funds and ETFs are.

Key Takeaways

  • Mutual funds are professionally managed pools of money that invest traditionally in stocks and bonds.
  • Some mutual funds, however, utilize derivatives contracts like options and futures to enhance returns or generate income.
  • Commodities funds will often hold futures contracts rather than the physical underlying asset.
  • Some equity funds can use options to either hedge away some risk or generate income through covered call writing.

Options and Futures in Commodities Mutual Funds

Mutual funds that specialize in generating returns from changes in commodities prices typically hold commodity futures and stocks of companies that extract and sell various commodities, such as oil, gold, gas, silver and other precious metals. Futures can be a substantial part of a mutual fund's holdings if a fund wants to pursue aggressive speculation and trading strategies that maximize the total return from the commodities market. Investing in commodities is very risky, and mutual funds typically utilize sophisticated investment techniques and hire highly competent management. This may result in a very high expense ratio charged by a commodities mutual fund.

For instance, the Rydex Basic Commodities Fund Class H (NASDAQ: RYMBX) invests in various exchange-traded products, including commodity-linked derivative instruments such as commodity options and futures. The fund charges a high gross expense ratio of 1.93% as of July 2020.

Equity Mutual Funds That Use Derivatives

Some mutual funds invest in stocks but also hold options with the purpose of minimizing the downside risk and volatility of their portfolios. Buying protective puts generally lowers overall returns since the options' premium must be paid, but they also prevent against severe losses in a bear market or market crash.

Others engage in covered call writing to generate income, such as the Gateway Fund Class A Shares (NASDAQ: GATEX) which invests primarily in large-cap equities included in the S&P 500 Index. However, the fund sells call options against its portfolio and uses proceeds to purchase put options, which allows GATEX to hedge its entire portfolio against volatility and sudden large drops in prices. (For more, see Put Option Basics.)