As a futures broker at Daniels Trading, I speak to investors every day about commodity futures trading. In speaking with these investors, I commonly hear that it is more convenient to trade ETF’s than futures. ETF’s appeal to individuals who want the diversification that ETF’s bring without the hassle of setting up a futures account. While I understand the trepidation of stepping outside your comfort zone, I think it is important to share with you what I call “hidden truths” when it comes to the “easy” path of using ETF’s as a diversification or trading vehicle.
Depending upon your tolerance for risk, you may find that futures might be the better alternative under the right circumstances. My hope is that in these few short paragraphs, I can arm you with the facts so you can make an informed decision for what is best for you.
What is an ETF?
ETF stands for “Exchange Traded Fund”. It is a security that tracks or follows an index, such as a commodity or a basket of assets. Much like a mutual fund, ETF’s are traded on an exchange. ETF’s experience price fluctuations during the trading day based on the activity of the underlying asset or commodity that it is following, such as gold or crude oil.
Did you know mutual funds collect management fees? ETF’s are certainly no exception. The fee structure varies from ETF to ETF. They are often viewed as inconsequential by some investors.
Managing a fund or an ETF costs money. Managers of securities such as ETF’s must cover these costs out of the investor’s pocket. Marketing and other management fees can add up quickly. Even rebalancing the ETF portfolio to improve the tracking of the underlying asset (gold, oil, corn) produces potentially hidden costs. Withdrawing money before a certain time may also produce an early distribution fee. Comparatively, when holding a futures contract over the long term, you may have to roll it to a futures dated contract which generates a brokerage commission and standard exchange fees. However, unless you are participating with a managed futures product such as a fund, you will not experience the draw of management fees against your account like an ETF would. The bottom line is that if the investor is seeking to parallel a specific commodity, the impact of fees may alter its ability to track accurately.
The leverage built into futures contracts allows for potentially greater returns and losses versus the securitized ETF counterpart, providing unrivaled capital efficiency.
For instance, on a $10,000 investment in gold:
- The SPDR Gold ETF, might give you exposure to 8 ounces; a $10 move in gold prices means your investment gain/lost $80.
- One full size gold futures contract gives you exposure to 100 ounces; a $10 move in gold produces or loses $1,000.
Again, leverage is a double edged sword. ETF’s are, in my opinion, a much more diluted product when evaluated in the realm of comparisons to the underlying asset, like gold or crude oil. The flip side is that futures offer a pure link to the underlying asset, but the risk is that you are leveraging a position; therefore, even a small move in the commodity can produce a large gain or loss.
Tracking the Commodity
At this point, I think we have begun to dispel common misconceptions about ETF products; futures are the transparent product. An unfortunate characteristic of ETF’s are how the instruments truly track a commodity’s performance. A majority of leveraged and non-leveraged funds use complex derivative strategies, like OTC swaps, as the basic infrastructure for mimicking movements in price. Often investors are referred to a complex prospectus that was written for lawyers by lawyers to disclose these activities. Such strategies, though professionally managed, may create significantly more risk for investors and traders. Even the most professional of derivative traders make mistakes, such as JP Morgan’s “London Whale”. Knowledge of how your investment is structured should be of the utmost importance simply because you are dedicating your hard earned money to it.
ETF’s attempt to parallel the performance of the commodity markets in three ways: Replication, Optimization, and Synthetic Replication. These concepts are intensive in nature, but we will cover the basics.
Replication is just buying the same assets as the underlying index and rebalancing when necessary. Optimization means investing in a subset of the underlying assets while sampling different components. Lastly, Synthetic Replication is a swap between the ETF’s sponsor bank and the fund; thus swapping returns of the funds individual investments for the returns of the index.
After getting through that definition, one has to ask the question, why not just invest in the actual commodity future? Why pay the fees, why dilute holdings and why use these synthetic investment vehicles when the real instruments are at your fingertips?
To be sure, there are substantial risks involved in investing in the futures markets, and futures are not right for everyone. Still, our job is to educate and shine a light on the facts so investors like you can make the best and most informed decision possible.
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