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Three Facts About Commodity ETFs

August 3, 2012 by DT Author| Tips & Strategies

Commodity ETFs vs. Futures

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 commodity ETFs than futures. Commodity ETFs appeal to individuals who want the diversification that ETFs 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 commodity ETFs 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, ETFs are traded on an exchange. Commodity ETFs 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.

ETF Fees

Did you know mutual funds collect management fees? ETFs 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 ETFs 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.

Leverage

THE RISK OF LOSS IN TRADING COMMODITY FUTURES AND OPTIONS CONTRACTS CAN BE SUBSTANTIAL. THERE IS A HIGH DEGREE OF LEVERAGE IN FUTURES TRADING BECAUSE OF SMALL MARGIN REQUIREMENTS. THIS LEVERAGE CAN WORK AGAINST YOU AS WELL AS FOR YOU AND CAN LEAD TO LARGE LOSSES AS WELL AS LARGE GAINS.

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. Commodity ETFs 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 ETFs 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. Investors are often 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.

Commodity ETFs 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 ETFs sponsor bank and the fund; thus swapping returns of the funds individual investments for the returns of the index.

Why?

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.


Discover how much you can save with futures with CME Group’s Equity Index Futures vs. ETFs Total Cost Analysis Tool

The Equity Index Futures vs. ETFs Total Cost Analysis Tool is designed to help you analyze the all-in costs of replicating the S&P 500 through equity index futures versus exchange-traded funds.

This tool focuses on three components of the total cost of trading – transaction, implementation and holding costs – and allows you to adjust inputs to fit your specific investment situation.

While this tool highlights the cost advantages of equity index futures relative to the corresponding ETFs, the calculations rely on a number of stated assumptions outlined in “The Big Picture: A Cost Comparison of Futures and ETFs,” which should be referenced with considering investment scenarios and costs.

Try the Equity Total Cost Analysis Tool

Futures vs. ETFs Online Course

Filed Under: Tips & Strategies

Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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