Why Futures May be the Better Choice Over ETFs

By Donna Heidkamp, RJO Futures Senior Trading Advisor

With the increasing concern of inflation and potential hyperinflation, investors have been looking for ways to diversify their portfolio to take advantage of higher commodity prices and many are deciding between trading ETFs (Exchange Traded Funds) or futures. In this article, we will discuss the differences between trading ETFs and futures to assist you in making an educated decision that fits your risk tolerance.

An ETF is similar to a mutual fund in that it consists of a basket of securities, which makes it much less transparent than futures. The primary difference is that mutual funds can only be bought and sold at the settlement price, while ETFs are traded like an individual stock, with availability to enter and exit throughout the trading day. ETFs are commonly considered when diversifying a portfolio because many are sector-specific. For example, the SPDR Gold Trust (GLD) is often traded by investors looking to increase their exposure of gold in their portfolio. (In SPDRs, each share contains one-tenth of the S&P index and trades at roughly one-tenth of the dollar-value level of the S&P 500. SPDRs can also refer to the general group of ETFs to which the Standard & Poor's depositary receipt belongs.) As an investor, you don’t have a choice as to which securities fall in the basket and your overall exposure may be much smaller than you think.

Futures contracts are the most transparent market that you can find. If you want to increase exposure in gold, you buy a gold or mini gold contract depending on your risk tolerance and trading objectives. Historically, energies, metals, and food markets tend to have the highest risk of inflation, in that order. Futures allow you to enter positions using either futures or options on futures to create your own inflation portfolio with your risk tolerance and time frame in mind.

Some of the fundamental differences in futures and ETFs include how and when they are traded. Futures contracts are traded on a recognized futures exchange that is regulated by the CFTC, and you must have a futures trading account to participate in this market. ETF shares are regulated by the SEC, and traded through a securities account.

When trading futures, you are charged a commission rate that may vary depending on your account service level and a few dollars in fees when an order is executed. When trading ETFs, you are charged a commission rate by your brokerage company as well. According to Yahoo! Finance, the value of the ETF will reflect the payment of fees associated with it, which are similar to those of a mutual fund, since it is run by a fund manager. A fund manager receives a small portion of the fund's annual assets as their fee, which can vary by ETF. The investor or company who loans the stocks to start the ETF earns interest and the custodial bank that holds the shares to start the ETF earns a small percentage. Investor fees should be clearly laid out in the prospectus for the ETF.

When trading ETFs, brokerage firms require that you put up at least 50% of the value of the shares you purchase. The remaining margin or balance that you borrow from the brokerage firm to cover the cost of the shares would be charged interest. If you were to take a short position in the ETF, you would be required to borrow shares from a broker and pay interest.

However, all futures contracts are purchased and sold using the same margin requirement (also referred to as a “good faith deposit”) through the exchange which is approximately 5 to 10% of the full cash value of the contract. For example, if the gold contract is based on 100 troy ounces and currently trading at $930.00 per ounce, the full cash value of the contract would be $930 x 100 = $93,000. According to exchange rules, you would need $5399 of initial margin in the account to hold a futures contract, or 5.8% of the full cash value of the contract. (Be aware that the exchange sets the margin requirements which can change at anytime as volatility changes in the market.) For this reason, traders often choose futures contracts over ETFs because of the ability to trade on leverage and the ease of going long or short the market. However, trading on leverage makes futures more risky due to the amount of capital involved and money management is extremely important.

Finally, at the moment, profits on futures contracts are taxed at a 60/40 split between long-term/short-term capital gains no matter how long a contract is held. The tax law is set up this way because all contracts have expiration dates. Another bonus includes the absence of itemizing each futures trade on the tax return. (Although the 60/40 split is a bonus, we must keep in mind that it may change with the proposed current changes in the tax code.) Since the ETFs do not expire, an investor can hold a position as long as desired. The ETF gains are charged short-term or long-term capital gains like other securities, depending on how long the investor holds the fund and the extent of the distributions.

Overall, futures offer more transparency than the ETFs. They also offer flexibility in creating a portfolio that is more highly-leveraged, with the same costs for trading both the long and short side of the market. As we are all aware, after the huge drawdown in the markets over the past year, it is not always in our best interest to buy and hold. As Dennis Gartman of The Gartman Letter often comments, it is the nature of the markets to ebb and flow.

The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.