Commodity ETF’s: Futures based vs Physical based

By: ispeculatornew
Date posted: 12.14.2010 (5:00 am) | Write a Comment  (7 Comments)

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ETF’s have been a game changer since arriving on the scene and I am a big fan of ETF’s as I’ve said in the past. That being said, not all ETF’s were created equal and among the 20 things that we look at when judging ETF’s are the index that they track. In commodities, that is very true. Some commodity ETF’s track the actual commodity while others get exposure through derivatives (futures or OTC products). It does end up making a major difference and I thought it would be interesting to look into both methods, their impacts and which you would prefer to go with if given the choice. It’s not a black or white choice obviously or else both would not co-exist as they currently do.

Physical ETF’s

Physical ETF’s are probably the easiest to understand. GLD, the largest commodity ETF is the perfect example. Buying it gives exposure to Gold and the way it’s done is very simple as each ETF that is created creates proceeds that are used to buy physical gold. That gold is then held on behalf of unit holders. In theory, you could exchange your units of GLD in exchange for bars of the precious metal. The same is done on other metals such as Silver (SLV).

Futures based

In other situations, buying the physical stuff is not as practical and oil ETF’s for example are usually created in a different way. These ETF’s will buy oil futures that would eventually become physical crude oil. However, the oil futures are always sold back and exchanged before getting to expiry (a process called the roll). That has pros and cons but the basic conclusion is that ETF holders do not have direct exposure to commodity and could not exchange it against anything but cash

Pros and Cons

There are many different issues and advantages to both of them, let’s take a look into the differences:

Contango effect: This has been well documented and much of the criticism towards commodity ETF’s is about the erosion that some of the funds have suffered when going through the “roll”. The main thing is that if a fund holds 1000 oil contracts at 70$ and must roll to the contract of the following month which is priced at $80, it will not be able to buy the same number of contracts. Because of that, the exposure to crude oil will be diminished – Advantage Physical

Perception: Another big problem for futures based ETF’s is that investors often do understand futures based ETF’s. What do I mean? When they buy an ETF on oil, they usually expect that when the news headlines discuss a 5% rise in oil, that their investment will have picked up the same. Not necessarily. In general, news headlines only mention the “front contract”, or the futures contract that is closest to maturity. When you are long the future, that is not necessarily the one that you are exposed to at all times.- Advantage Physical

Trading Costs: Futures based ETF’s usually do futures rolls every month which over time can mean a lot of trading costs involved. If you are holding the ETF over a few years, it will have an impact on your performance without any doubt..- Advantage Physical

Storage Costs: This one is also very straight forward. Imagine a fund like GLD, which  has close to $60 billion worth of gold. Can you imagine how much money is involved to buy, transport, store and secure all of this gold? There is probably insurance involved in case something happened (sophisticated hold-up, etc). You can imagine how much costs are involved. Now imagine the same for an oil etf, which would hold so much oil. It would cost millions of dollars in storage alone would be incredibly high. – Advantage Futures based

Apocalypse: I’ve discussed this in the past but many investors want a portion of their portfolio into “worst case” scenarios and in that scenario, buying the physical commodity is on top of their list, followed by physical based ETF’s. Futures based ETF’s which often depend on the financial system on counterparties being able to pay up,  are generally not seen as being “as safe”.

In fact, there is no real choice

I might be wrong but I looked through many many of the largest US ETF’s and could not find a security that has both a physical and a futures based ETF. Metal ETF’s seem to all be physical based while energy ones such as oil and natural gas are futures based. The logical explanation would be that the the energy ones are much more expensive to buy. You can take a look at the largest commodity ETF’s and what they are based off. Let me know if you find any errors as finding these did take some time but in general I’m confident. I did take away “broad commodity ETF’s” which track many different ETF’s. For obvious reasons, those would all be futures based.

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Will it come?

No doubt, I’m very surprised to not see a commodity that has both types of ETF’s, which would have been interesting for comparison’s sake. I would think that metal ETF’s, especially in the case of gold, which is very liquid, could very well make its entry. The problem involved is that buyers of gold are often the same ones worried about a fallout of the entire system which often translates into a preference for physical based ETF’s.

Do you have a preference for either?

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7 Comments

  1. Comment by VeRo — December 14, 2010 @ 7:31 am

    Learned something again today because of you! I also thought that Gold could have both. I mean, I don’t understand why it could not be futures like oil. But as an investor, I’d rather have mostly physical with a bit of futures. You?

  2. Comment by IS — December 14, 2010 @ 11:48 am

    @VeRo – I guess it depends but yes, I would also generally prefer physical if the price to do so is reasonable:)

  3. Comment by Narayan — January 2, 2011 @ 7:04 am

    One thing is not clear of the contango effect from this article. You say 1000 contracts at $70 get repriced to $80 next month and the contracts are rolled. Does the ETF not track the net dollar value of the underlying contracts? If so, that should not affect the ETF due to the roll? Will appreciate if you could explain what is it that I am missing?

  4. Comment by IS — January 2, 2011 @ 8:54 am

    @Narayan. Sure, let’s say USO own 100 contracts of January crude oil today, here are the prices:

    January Crude contract= 100$
    February Crude contract = 100$

    If 10 days later, when it is time to roll, these are the prices:

    January Crude contract = 100$
    February Crude contract = 110$

    You can see how the January contract did not move as much as the February one. Many things could cause this but that is what I mean.

  5. Comment by IS — January 2, 2011 @ 8:56 am

    @Narayan. Sure, let’s say USO own 100 contracts of January crude oil today, here are the prices:

    January Crude contract= 100$
    February Crude contract = 100$

    If 10 days later, when it is time to roll, these are the prices:

    January Crude contract = 100$
    February Crude contract = 110$

    You can see how the January contract did not move as much as the February one. Many things could cause this but that is what I mean. Does that help?

  6. Comment by Bob — April 28, 2011 @ 10:15 pm

    Thanks for the good article. Me and probably many others are now well aware of the danger’s of using commodity ETFs based on futures contracts.

    Take UNG (natural gas) for example, it was poorly structured and the investors were getting burned bad every time by contango when they had to roll over the contracts. The whole thing is a big joke. The fund lost 90% of its value even when the price of natural gas when up.

    I personally find the physically-based commodities ETFs to be the only ones worth investing into.

    When the ETF says “Gold” you want it actually track the spot price of gold with no games or contango. Its simple and straightforward.

    Commodity ETFs are still new. The energy and agriculture commodity ETF were lazy by relying on contracts. They took the easy way when creating these instruments.

    A contract simply is not the same as owning. I hope in the future that more physically based ETFs are formed. For example, an oil ETF that has an actual area with tons of OIL storage tanks storing it. Or a corn ETF that owns lots of farmland with actual corning growing.

  7. Comment by IS — April 29, 2011 @ 4:36 am

    @Bob Very well said, it’s a good example. I would simply add that taking costs into account is also critical. For example, owning physical oil is much more tricky and costly than owning physical gold.

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