By Aaron Fennell and David Berglas
Exchange Traded Funds (ETFs) are now among the most heavily traded stocks, making up over 30 percent of the trading volume of the NYSE and over 15 percent of the trading volume on the TSX. Commodity-based ETFs use commodity futures, or over-the-counter forward contacts, as underlying assets. They are often seen as a convenient method of gaining exposure to the asset class, but they are inferior to their respective futures contracts in many ways.
Leveraged ETFs
Many commodity ETFs are leveraged, and should not be used for holding long-term positions. ETFs with “2x,” “ultra,” “bull/bear” or “leveraged” in their name are typically leveraged funds that are rebalanced daily. The purpose of this rebalancing is for the fund to achieve a leveraged return that mirrors the daily movement of the underlying asset. Rebalancing systematically erodes the net asset value underpinning the units by purchasing more of the underlying commodity futures when the price has increased, and selling the excess underlying when the price has declined. The rebalancing results in systematic buy high, sell low trading activity.
Example:
An underlying asset and its respective “2X Daily Returns” ETF each start with a value of $100. The ETF’s price change is two times greater the daily change in the underlying.
Daily | Underlying Asset | 2X Daily Return ETF | |
| Start | --- | 100 | 100 |
| Day1 | 20% | 120 | 140 |
| Day2 | -20% | 96 | 84 |
| Day3 | 20% | 115.2 | 117.6 |
| Day4 | -20% | 92.16 | 70.56 |
| Day5 | 20% | 110.59 | 98.78 |
| Total | Returns | 10.59% | -1.22% |
Notice on day 2 (highlighted), the ETF decreases by $56 (2X Leverage x (-20% Daily Return) x $140 Start of Day = $56)
After Day 5, the ETFs value is lower than the underlying, and is even lower than its own starting value. The price erosion is catalyzed by volatility; the greater the volatility the greater the erosion. In the above example, the volatilities have been exaggerated to dramatize their effect. In reality, on a longer-term schedule a similar source of erosion can be expected. Further, the above figures ignore management fees and brokerage fees which would further erode the value of the ETF. It is for these reasons that the prospectuses of leveraged ETFs clearly state that the units are meant for day trading and should not be used for position trading.
Non-Leveraged ETFs
Even if ETFs aren’t leveraged/rebalanced, there are still several advantages to trading with futures.
Most commodity ETFs use futures or forward contracts to underpin their pricing characteristics. The price of the ETF cannot possibly directly track the underlying assets more efficiently than the futures contracts themselves. Thus, traders are exposed to corresponding net asset value correlation risk.
ETF unit holders are also subjected to counterparty risk. The invested funds of an ETF are typically entrusted to the sponsor of the ETF and subsequently applied to a complex system of structuring and over-the-counter derivatives. In the event that a counterparty of the ETF fails to perform on its obligations, the net asset value of the ETF could be adversely impacted. Although this risk is very minimal, since 2008 we have already seen the most stable institutions susceptible to default risk. Conversely, futures contracts are guaranteed by the clearing corporations of the exchange, so there is virtually no risk of default.
Additionally, futures contracts allow for more complex strategies such as inter-commodity spreads and calendar spreads. This allows futures traders to take advantage of more complex or interesting pricing relationships. For example, one could purchase natural gas and short crude oil to take advantage of a changing price relationship between the two energy sources. Or, traders can take advantage of seasonal relationships in commodity pricing. Commodity-based ETFs only allow for simplistic long or short commodity trading strategies.
Finally, futures contracts offer traders more leverage. Most ETF units limit leverage to 2 to 1, but futures contracts offer leverage of 10 to 1, or even 20 to 1 in some cases. Further, the leverage on a futures contract is clear and exact, but the leverage ratio of an ETF is an estimate and will fluctuate around a target leverage ratio. It is important to remember that leverage magnifies both the risk and the reward of a potential trading strategy.
In closing, leveraged/rebalancing ETFs can be a very ineffective and potentially damaging way to gain exposure to commodities. In many ways, even when used for day trading only, or when using non-leveraged/rebalancing funds, ETFs are still inferior to trading with futures. Unlike ETFs, futures are flexible with respect to strategy and leverage, they are priced efficiently, and they are virtually free of counterparty risk.
Aaron Fennell and David Berglas are market strategists based in Lind-Waldock Toronto-based office. If you would like to learn more about futures trading you can contact them at 877-840-5333.
The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results. Please carefully consider your financial condition prior to making any investments. Not to be construed as solicitation.
(c) 2010 MF Global Holdings Ltd. Lind-Waldock, a division of MF Global Canada Co. MF Global Canada Co. is a member of the Canadian Investor Protection Fund.
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