The world’s largest commodity ETF, DBC, has fallen 18.4% YTD and at $15.04 per share, is now trading well under its 2009 low of $19.11.
Commodities across the board have taken a hard hit recently as economies across the globe have slowed. The Chinese economy is slowing, developed country imports are falling, and OPEC is flooding the oil markets with crude. These situations have driven commodity prices down to historically low levels and investors have taken notice.
True “sales” are hard to come by in global finance, but the commodities market is currently offering a “firesale”. Prices are so low that even long-term value investors can make a case to diversify into commodities and hold long term, with the intent of reaping large gains if prices return to just production breakevens.
Futures or ETFs?
By the raw numbers, futures generally outperform their ETF counterparts, but this is expected. ETFs are usually constructed using futures or futures option positions and charge fees for their services which makes them more expensive than direct futures positions. In addition direct futures contracts are less volatile than their ETF brethren, but due to their expiration dates require investors to have more skill timing the market.
However, ETFs provide value in different ways to their investor. For example, commodity ETFs are extremely simple to invest in and manage as a retail investor because they can be purchased and sold like equity. Also, commodity ETFs usually have a low cost per share, so hedging actions can be done with more granularity.
Below we’ve outlined the major “pros” and “cons” of each asset class. In this simplified form, it should make choosing between futures and ETFs easier for investors looking to dip a toe into commodities markets.
- Higher returns than ETFs, with less volatility.
- Higher leverage: when you buy a commodities futures contract you typically only have to post 10% of the overall value of the contract.
- The Commitment of Traders Report allows you to see what other participants in the market are doing.
- Futures are transparent: when you buy or sell a future, you know exactly what you own and when your contract expires.
- Higher cost of investing in futures contracts, due to the large size of each contract. The large size of these contracts can limit the ability for a retail investor to diversify their holdings.
- Futures are complicated for the common investor because they are different than stocks. A future represents an agreement to buy or sell a commodity at a given price, on a given day and expires upon the day of delivery. While a stock represents a small piece of a much larger company that never expires.
- You have to time it right. A large component of futures prices is time. If you do not time the market correctly, your futures position can expire at a loss even if you were eventually correct.
- Simple shares-based trading. The management company handles the complicated buying and selling of the commodities futures.
- Low share prices allow for better hedging and a small initial investment.
- You do not have to time the market. The managers of the ETF continually enact their strategy and you do not have to worry about day-to-day trading.
- Lower returns and higher volatility than directly investing in futures. This is due to the management strategy of tracking the futures and the fees associated with running the ETF.
- Less liquid than futures.
- Less leverage. Unless you are buying the ETF on margin, the full value of the shares is required up front, in order to purchase shares in the commodity ETF.
- ETFs are less transparent than directly investing in futures. With a complicated ETF strategy it can be difficult to discern the exact strategy the managers are using to mimic the futures prices (e.g., futures, options, or a mix).
The Bottom Line
Futures are hard, complicated and expensive! Leave these to the experts. If you are a smaller retail investor, don’t waste your time learning the details of the futures markets. The initial investment is likely too high and the skill needed to time the market is great. Simply invest in a commodity ETF that manages the futures for you and pay a little for their expert services. Even paying a little bit more you will still make a killing if you manage to pick the bottom on the commodities markets.
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