Futures For You
| INSIDE THE FUTURES WORLD
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O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com),
responds to your questions about today's futures markets.
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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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