The capital markets feature a vast array of products, each designed to fulfill a certain purpose. Whether you’re interested in making long-term investments, holding intermediate-term positions, or engaging in short-term intraday trading, there is a security well suited to your goals. Two of the most popular are futures contracts and leveraged ETFs.
What Is a Futures Contract?
A futures contract is a legally binding, exchange-traded financial product. It outlines the purchase or sale of a specific quantity of an underlying asset at some forthcoming point in time. All futures are assigned an expiration date, and the contract ceases to be tradable when that date is reached.
With futures, traders are able to secure bullish or bearish market exposure by either buying or selling a contract. Additionally, the terms of all futures transactions are clearly defined by each contact’s specifications, which are determined by the exchange.
What Is a Leveraged ETF?
A “leveraged” or “geared” exchange-traded fund (ETF) uses financial derivatives to amplify the returns on an underlying asset or index. Leveraged ETFs are used to engage a wide variety of sectors, including equities, commodities, and currencies. Functionally, they come in two types:
- Standard: A standard leveraged ETF is designed to enhance returns on a bullish market position. Typically, returns are boosted by two or three times (2X, 3X) the underlying asset’s or index’s return.
- Inverse: An inverse ETF furnishes traders with bearish exposure to a market. Inverse ETFs may also be leveraged by two or three times to enhance returns.
With geared ETFs, traders can secure long or short exposure in a wide variety of markets. For instance, the popular ProShares UltraPro QQQ (TQQQ) attempts to deliver three times the daily return on the NASDAQ 100 index. To pursue this goal, the fund is nondiversified and uses a combination of swap agreements, futures contracts, and other “similar instruments” to generate returns.
Futures vs. Leveraged ETFs: Pros and Cons
Although futures and leveraged ETF functionality are similar, the two differ in a few key areas.
Direct/Indirect Market Exposure
Although both products may be used to gain exposure to currency, commodity, debt, and equity markets, they do so in unique fashions. Futures contracts offer direct exposure, meaning that their price is based solely on the performance of the underlying asset. Conversely, a leveraged ETF can combine any number of instruments to gain indirect exposure and produce stated returns.
The indirect exposure causes two issues for geared ETFs:
- Tracking errors: A tracking error is a discrepancy between the performance of the ETF and its underlying asset or index. Tracking errors can be significant if the pricing of fund components deviates from the asset or index in question.
- Time decay: Leveraged ETFs are required to rebalance leveraged positions on a daily basis. Thus, during volatile periods, the fund’s assets are increased or decreased to reflect the change in net asset value (NAV). Over time, this can be a major factor impacting performance.
In reality, futures contracts aren’t faced with problems such as time decay or tracking errors. If you’re interested in taking a long or short position on a specific asset, then futures contracts are the way to go.
Financial derivatives are leveraged products that are normally traded on margin. Futures margins come in several types, including day and overnight requirements. Depending on market volatility, the capital outlay needed to hold a futures position through a daily or weekly close can be significant.
By contrast, leveraged ETFs don’t require distinct overnight margin allocations and may be held indefinitely. However, because of tracking errors and time decay, this isn’t necessarily a good idea. Also, U.S. Securities and Exchange Commission (SEC) rules deem that to trade geared ETFs on margin, requirements are 25 percent multiplied by the degree of leverage (not to exceed 100 percent). So, to trade a 3X ETF on margin, 75 percent of the market value is required, and this capital outlay far exceeds the standard 3-12 percent of futures.
What Will It Be? Futures or ETFs?
From a practical standpoint, futures offer direct market exposure and reduced margin requirements, whereas geared ETFs are simple to trade and may be purchased outright from a zero-commission brokerage. However, given the negative impacts of time decay and tracking errors, using a buy-and-hold leveraged ETF strategy is rarely a good idea.
To learn more about whether futures or ETFs are best suited for the pursuit of your financial goals, schedule a free consultation with a Daniels Trading market professional. A simple talk with an industry expert can shed some light on the pros and cons of each of these types of products and guide you to success in the markets.