ETFs have been a game changer since arriving on the scene and I am a big fan of ETFs as I’ve said in the past. That being said, not all ETFs were created equal and among the 20 things that we look at when judging ETFs are the index that they track. In commodities, that is very true. Some commodity ETFs 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 they would not co-exist as they currently do.
Physical ETFs 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).
In other situations, buying the physical stuff is not as practical and oil ETFs, for example, are usually created in a different way. These ETFs 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 the 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 at the differences:
- Contango effect: This has been well documented and much of the criticism towards commodity ETFs 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 ETFs is that investors often do not understand futures based ETFs. 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 ETFs 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. – Advantage Futures based
- Apocalypse: I’ve discussed this in the past but many investors want a portion of their portfolio in “worst case” scenarios and in that scenario, buying the physical commodity is on top of their list, followed by physical based ETFs. Futures based ETFs which often depend on the financial system and the counterparties being able to pay up, are generally not seen as being “as safe”. - Advantage Physical
In fact, there is no real choice
I might be wrong but I looked through many of the largest US ETFs and could not find a security that has both a physical and a futures based ETF. Metal ETFs 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 energy ones are much more expensive to buy. You can take a look at the largest commodity ETFs 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 ETFs” which track many different ETFs. For obvious reasons, those would all be futures based.
Ticker Name Market Cap Price Fees 1Y Return Tracks GLD SPDR Gold Shares $57,784,480,000.00 138.07 0.4 13.442 Physical SLV iShares Silver Trust $9,901,186,000.00 28.5975 0.5 47.856 Physical IAU iShares Gold Trust $4,803,150,000.00 13.82 0.25 13.45 Physical UNG United States Natural Gas Fund LP $2,711,610,000.00 5.94 0.6 -31.724 Futures based DBA PowerShares DB Agriculture Fund $2,403,493,000.00 30.36 0.85 12.571 Futures based USO United States Oil Fund LP $1,941,378,000.00 38.31 0.45 -2.755 Futures based SGOL ETFS Gold Trust $1,109,370,000.00 140.77 0.39 13.443 Physical OIL iPath Goldman Sachs Crude Oil Total Return Index ETN $628,005,400.00 25.17 0.75 -3.353 Futures based PPLT ETFS Platinum Trust $624,150,000.00 171.85 0.6 N/A Physical DBO PowerShares DB Oil Fund $599,649,100.00 27.03 0.75 -3.427 Futures based
Will it come?
No doubt, I’m very surprised to not see a commodity that has both types of ETFs, which would have been interesting for comparison’s sake. I would think that metal ETFs, 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 ETFs.
Do you have a preference for either?