Many investors wanting to participate in commodity markets such as gold, silver, crude oil and even the broad equity or bond market
do so with exchange-traded funds, or ETFs. An ETF represents ownership in a unit investment trust or fund that is based upon a basket of
commodities, securities or other assets. ETFs are traded on a regulated exchange
and through a stock brokerage account much like individual stocks.
Using market and limit orders, shorting, and buying on margin can be done with ETF shares in the same manner as with a stock.
The primary benefit of an ETF is diversification: with the simple purchase of an ETF share, the investor can immediately
gain exposure to a particular commodity or to a wide range of securities or other investable assets without having to
acquire each separately and all within the same stock brokerage account. As such,
ETFs are an efficient tool to manage the overall asset allocation of an investment portfolio.
Exposure to these commodity markets, including the broad financial markets, has been traditionally available through exchange-traded
commodity and financial futures contracts and, while an investor who has a stock brokerage account may find it convenient to rely on
ETFs for this exposure, whether or not an ETF represents the better investment choice over a corresponding futures will depend upon
several criteria.
Trading Horizon
ETFs become less efficient vehicles when the trading horizon is short, for example, less than one year. In addition to
taxation issues,
trading costs in terms of the brokerage commission
and the bid-ask spread can become significant relative to the profit or loss realized on an ETF trade over a short time period.
Depending upon liquidity, some ETFs may have a fairly wide bid-ask spread and it may even be difficult to
execute trades quickly.
Futures are better designed for short-term trading, even day trading, not only because of their liquidity but because of their high
leverage
that amplifies the gain or loss associated with a market price movement. Consequently, even though brokerage and/or other types of trading fees are
incurred when trading futures, they are typically small in relation to the resulting profit or loss on a trade.
With regard to taxation, net capital gains on a futures trade, even when held for a short period, benefit from the automatic
60/40 rule.
ETFs are, in general, better designed for long-term trades than a futures position. Apart from taxation issues,
a futures position needs to be continuously rolled from one contract to the next, incurring a commission expense, as each expires in turn.
Desired Exposure
Certainly, an ETF will be the logical, and only choice, when it provides exposure to an area that has no counterpart in the
futures market or any other market, for example, style-based ETFs that focus on growth, value or capitalization, or theme-based ETFs
such as those aimed at green or socially responsible investors.
However, when an ETF is based on essentially the same commodity or index as a futures contract, then the futures will
often be the better choice as it does not have the tracking error typical of ETFs. This is especially true of index futures since the
futures contract by definition settles at expiration to the index value.
There will, though, be a minor deviation between the futures and the index owing to changes in the basis.
ETFs that gain exposure to commodities by investing in futures contracts can sometimes have distorted returns relative to the
price movement of the commodity itself as a consequence of the price differential operating during contract rolls.
In particular, large gaps in price from one contract that is expiring to the subsequent contract introduce risk
and volatility in the ETF performance, potentially driving it further from the performance of the underlying market.
In this case, the investor may prefer to hold the futures contracts directly, instead of the ETF, and exercise
personal control over contract rolls.
Options Availability
Many futures have a relatively liquid option market counterpart enabling the construction of a variety of futures and options-related
trading strategies, including important hedging strategies. Options on ETFs, in contrast, are usually traded very thinly if at all.
Available Capital
A minimum amount of cash is needed to buy or sell a futures contract in order
to meet the margin requirement and this can be expensive depending upon the contract market. As well, if prices
move adversely, the customer will be required to have cash in the futures trading account sufficient to cover any
loss on a day-to-day basis in addition to covering the required margin.
In contrast, there is no minimum purchase requirement for an ETF, other than the cost of one share. However, commission which is typically
charged on a transaction basis can become a significant expense for those who buy ETFs frequently and in small amounts, unless commissions
are reduced or waived as part of a broker promotion. If not, it would be better to buy ETFs less frequently but in larger quantity.
Beyond this, there is a minimum cash deposit required to open a trading account, whether for trading ETFs or futures (some firms allow
trading of both within the same account) and this may lie outside the reach of those with limited trading capital. These individuals
may want to consider an alternative market that is more accessible, namely, binary options. For more information, please see our
Binary Options trading site.
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