Futures For You
| INSIDE THE FUTURES WORLD
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Dan O'Neil |
ETFs vs. FUTURES
I've been reading about commodities-based exchange traded funds and am wondering about the differences between investing in exchange traded funds (ETFs) and investing directly in the futures markets. Does one have any major advantages over the other?
It's no secret ETFs have emerged as an increasingly popular investment option for individual investors. What started as a lightly regarded curiosity in 1993 with the debut of a single ETF tied to the Standard & Poor's 500 has exploded into a booming mainstream marketplace, with more than 300 specialty ETFs now being offered by a host of investment firms. Most ETFs are essentially baskets of securities that track an index, much like plain-vanilla index mutual funds, but trade like stocks on a regular stock exchange.
ETFs tend to appeal to investors who like to dabble in particular market sectors but perhaps lack the dedication to dig into them. Someone who's interested in adding an energy component to his or her stock portfolio may choose the basket approach of an energy-focused ETF over the idea of researching, investing in, and monitoring a number of individual utility companies.
As the market has become more specialized within the past few years, many investors have turned to ETFs to add commodities to their investment mixes. Many commodities-based ETFs started in the precious metals, actually buying the raw commodities to hold. Despite the growing attractiveness of ETFs in many corners, it's important to point out that trading in the commodity-based offspring of this movement is still a different animal than trading in the actual commodities markets. Here's a quick summary of why futures can be a better alternative to ETFs:
Product range: While the current crop of ETFS allows an investor to dip into some of the popular precious metals and a handful of indexes, futures traders can choose from a universe of products that includes hundreds of different possibilities. In other words, while ETFs can offer a taste of commodities for one's portfolio, at present they hardly scratch the surface of what's truly available in the futures markets.
Contract size: In a number of cases, futures are a more efficient way to control a given quantity or amount of a particular commodity than ETFs. You have to buy 10 shares in flagship gold ETF iShares Gold Trust to control just one troy ounce, for instance. But one gold futures contract represents 100 troy ounces of gold. Therefore, the equivalent ETF position would require the purchase of 1,000 shares.
Leverage: Many traders see the low margin requirements and tremendous leverage afforded by futures to be a major advantage. Consider this: The purchase of just a single CBOT gold futures contract currently covers about $60,000 worth of gold but requires an exchange minimum initial margin deposit of just over $2,700 (based on recent market prices). Equivalent minimum margin (50% Reg T) for the ETF position would require a deposit of approximately $30,000.
Trading hours: Shares of ETFs are traded on stock exchanges, meaning they're subject to the same relatively limited trading hours as any common stock transaction. While these restrictions may not seem unusual to veteran stock traders, anyone who has traded futures markets directly will likely miss the almost round-the-clock accessibility. CBOT gold futures again provide a great example -- they trade from 6:16 pm to 4:00 pm Chicago time, for example, allowing traders to act whenever an opportunity arises, almost 22 hours per day.
Costs/fees: While ETFs are lauded for their reduced fee structures compared with mutual funds, even these scaled-back charges can cut into one's profit potential - management fees are applied on top of the brokerage charges and exchange fees incurred when buying or selling shares in the ETF. Note too that ETFs pay their annual expenses (about 0.40%) by selling some of the gold they hold, putting slight downward pressure on the ETF share price over time. Trading futures directly, on the other hand, incurs no management fees, and transaction fees don't amount to much in percentage terms.
Taxes: Some futures contracts may offer a smaller tax bite than competing ETFs. Gold ETFs buy gold bullion, which is treated by the Internal Revenue Service (IRS) as a precious-metal collectible and taxed at 28%. By contrast, the general tax treatment for gold futures is that 60% of gains (or losses) are considered long-term capital gains, and 40% of gains (or losses) are short-term capital gains. This blends to a maximum federal income tax rate of 23%.
In the end, commodities-based exchange traded funds are likely a better fit for an investor looking to plug a hole in his or her overall portfolio with a simple patch of diversity. However, serious traders who are interested in trading commodities and taking advantage of the many benefits of the futures markets would do better by going directly to the source.
Originally published in the December 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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