(02/01/13) Commodity ETFs or Futures?

Commodity trader Andy Waldock discusses the divergences between investing in commodity ETFs as opposed to buying futures.

Trading commodities versus trading commodity ETFs. We’re here with Andy Waldock, who is going to tell us how they differ from one another and what advantages and disadvantages they both have.

Well, the primary difference and the major capital advantage to trading commodities versus the ETFs is the difference between margin money versus full face value.

When you trade an ETF, if you want to buy $10,000 worth of GLD, you have to put up the full $10,000. Whereas, if you want to control 1,000 ounces of gold, you only have to put the margin money for that. Typically it’s around 10% of contract value, so that allows you to allocate the other 90% of your overall fund into other interest-earning resources. Or just have free cash available for whatever you may need it for.

The second major difference are the reporting characteristics between the ETFs and the futures. If you look through the ETFs, you can find out who the underwriters are and who the primary holders are of those ETFs, and what their purposes are and their expense ratios.

In the commodity futures market, we use a report called the Commitments of Traders Report. It comes out weekly. It’s published by the Commodities Futures Trading Commission. What it provides to us are the net changes of the producers and end-line consumers of those commodities.

It’s always been my belief coming from three generations of hog farming and commodity trading and brokerage that the suppliers or the end users are the ones who understand the true values of their markets. That report, that weekly report, allows us to figure out if producers think that these are the best prices they’re going to see for a while and they’re selling, selling, selling, or whether the end-line users, you know General Mills (GIS) is looking to buy all the corn they can get for the upcoming year’s production and they’re buying, buying, buying. Either way, it’s a very key piece of information that not many people know about.

Now two questions come up that. With the ETFs, you also have an issue when you read the prospectus and you find out what they’re holding. I mean, sometimes the other piece of this...obviously with gold they might just be buying the bullion, they could be buying the futures. There’s a lot of nuances with the ETFs that they don’t really tell you necessarily on the front end. And sometimes if you’re just buying a basket ETF, you could be holding all sorts of different things. Whereas if you’re holding the commodity, you’ve got the commodity.

Absolutely. We look at, a good example would be the XLE energy sector. It’s made of drillers and refiners. There are several different companies within that XLE ETF; whereas, if you want to own crude oil, you own crude oil.

If you believe that the play is in the derivatives, in the unleaded gasoline or the heating oil, then you can work on the derivatives. There are times when you want to spread two derivatives against each other or three derivatives against each other through a crack spread. So it provides you with much more focused investment opportunities.

We were talking about gold earlier. You were talking about being able to buy on margin, where you can’t really do that and move that capital aside. You do have to keep some of that capital in case there are margin calls, depending on how leveraged you are in your position, right? The less leveraged you are, the less chance there is going to be a margin call.

That is definitely an advantage of the ETF. If you want to put your money in an ETF and go to sleep and never worry about the price and look at it years from now, that’s the way you should invest. However, if you want to own the particular commodity or you want to maximize your capital opportunities, the futures or options may be the best way to use it.

The time horizons are a little bit different too. Like you said, if you have an ETF and you’re waiting for the demographics in China and India to raise the price of copper, that’s a little different than trying to make the move in gold because of the election or inflation.

You’re right. When it comes right down to it, I am a trader. So if I can be in a good trade for a couple of weeks, three weeks, that’s a great trade.