By Noble DraKoln
Founder of Speculator Academy and Author of “Winning the Trading Game” and “Trade Like a Pro”
Significant differences in the liquidity, leverage, and costs of futures and ETFs must be understood before making any investment decision.
Gold has historically served as a legitimate hedge against inflation and an integral part of a diversified investment portfolio. But how can individual investors participate in the resurgence of gold and use gold as a vehicle for investing, preserving, and increasing one’s wealth?
Today, more than at any other time in history, active investors have available a variety of ways to invest in the performance of gold. In addition, individuals have flocked into gold-related investments, from gold bars to mining stocks or derivatives, to benefit from the renewed interest in gold. As a result, two of the more popular gold investments chosen by professional money managers are Gold futures (COMEX) and exchange-traded funds (ETFs) based on gold. In many cases, either the futures or ETFs are a suitable choice. Still, there are significant differences in the liquidity, leverage, and costs of each that need to be understood before any investment decision is made.
Differences in market liquidity
It’s estimated that world gold reserves fall between 120,000 and 140,000 metric tons. The largest gold ETF, SPDR Gold Shares ETF(GLD), is in its fifth year of existence with a total of $42 billion under management and 1,100 metric tons of gold bullion in reserve. Originally founded in 2004, the SPDR ETF was specifically developed to track the price of gold and become an inexpensive alternative to owning physical gold. Investors can purchase a share in the ETF, representing one-tenth of an ounce of gold. It sounds great in theory, but the amount of bullion under management is fairly insignificant. The volume of gold traded by the SPDR ETF is fairly small compared to the daily volume transacted using COMEX Gold futures. Source: Bloomberg
Currently, the SPDR Gold ETF trades an average of 24 million shares(GLD) daily, representing 2.4 million ounces of gold. In comparison, the average daily volume for COMEX Gold futures is over 200,000 contracts, equating to approximately 20 million ounces changing hands daily with an additional 48 million ounces (or 1,366 metric tons) held in open positions. Over 90 percent of these futures contracts are traded electronically. This, combined with a large number of market participants and the significant daily volume, makes the futures markets very efficient. And all transactions, as well as the best bids and offers, are publicly available in real-time, enhancing liquidity and providing what is known as transparent price discovery. Transparent pricing and small bid-ask spreads are key to a market’s success and a great benefit to
the investors who use them.
COMEX Gold futures = 20 million ounces/day
SPDR Gold ETF = 2.4 million ounces/day
Opportunities for leverage
To put it plainly, gold ETFs don’t provide leverage. Many securities brokers will loan you 50 percent of the money to purchase stocks or ETFs, but similar to any loan, there are costs associated with this. A unique feature of futures contracts is the ability to use leverage built into each contract via margin rules and regulations. Brokerage firms extend the exchange-enforced minimum margin requirements to their customers and manage the daily margining of their customer accounts. Margin can sometimes represent as little as three percent of the contract’s notional value. This is a tremendous advantage for investors who wish to use leverage to take advantage of a specific opportunity in the market. However, unlike stocks, futures margin is not a partial payment or a down payment for purchasing the underlying asset; it is simply “good-faith money.” This money is placed on deposit to guarantee that each participant can perform to the terms of the contract and withstand the average daily price fluctuation of the underlying asset. Brokerage firms constantly monitor margin balances and update account balances to reflect changes in market prices at the end of each day. If market conditions change, so may the exchange required margin required to trade that market, but there is never a need to borrow money from a broker, nor are there fees associated with using this margin.
At current prices, a $5,000 investment in a gold ETF would buy you shares that equate to approximately four ounces of gold. While an investment of $5,000 represents a substantial amount of money, gold would need to make a fairly significant move before an investor would see any real profits. On the other hand, that same $5,000 placed in a margin account allows the futures trader to benefit from the movement of up to 100 ounces of gold through the purchase or sale of COMEX Gold futures. This strategy can provide more than 25 times the potential to make profits from the same move in gold (miNY and E-mini Gold futures contracts can also be traded, which are smaller in size and require less margin).
Of course, there is no need to utilize all of the leverage available. Each investor can tailor their leverage to meet their investment goals. This is done by simply adjusting the amount of margin on deposit in relation to the value of the contract. The benefit of leverage is tempered by the fact that leverage magnifies both profits and losses. This means that investors who choose to use leverage should also protect themselves using prudent money management techniques. Using stop loss orders “stops” to limit the investors’ financial exposure to fast-moving markets is one common technique used by futures traders.
COMPARATIVE RETURNS: ETF VS. FUTURES
|SPDR Gold ETF||COMEX Gold futures||COMEX mINY Gold Futures|
|Amount of Gold||4 oz.||100 oz.||50 oz.|
|Value of a $10.00 move in Gold||$40.00||$1,000||$500|
|Return on investment||0.8%||20.0%||20.0%|
Minimizing Tracking Error
Compared to an investor trading gold futures, an individual who invests in an ETF will be exposed to costs and fees in addition to brokerage and ETF creation/redemption fees. Many of the costs of owning an ETF revolve around management fees and the associated taxes. These sometimes hidden costs can affect the pricing of the ETF itself and have very little to do with the actual price of gold.
By virtue of the asset class, gold (a physical commodity) produces no income. This presents a problem for the ETF manager since the fund generates ongoing administrative expenses. Whether management fees (usually about 40 basis points), marketing fees, or general expenses, gold bullion from the fund must be sold to cover these expenses. When the fund does so, it may incur additional transactional costs. This sale of gold diminishes the ETF’s overall holdings and erodes its value over time, resulting in what is known as a tracking error.
In contrast, gold futures contracts do not experience any of these issues. As a result, investors can buy or sell gold on the open market at their discretion and avoid the related management fees. Therefore, COMEXGold futures, which are often used for investment instead of acquiring physical bullion, can be arbitraged against gold bullion and have no measurable tracking error. However, long-term investors should note that futures positions may need to be rolled forward (exiting one contract and entering into a new one) to a contract with a deferred expiration to maintain a job longer than the original contract’s length may result in an additional brokerage cost.
Further Tax Implications
Another cost associated with owning shares in gold ETFs instead of investing in futures is the tax implication. Gold futures may also present tax advantages for certain investors. This is not intended to be advice regarding tax treatment, and we advise that you contact your tax attorney or accountant for information that applies to your situation.
Taking physical Delivery
The futures and gold ETFs provide a mechanism for physically delivering gold. Investors interested in obtaining gold through the purchase of COMEX Gold futures or gold ETFs should recognize that standard procedures and quantities are used for delivery and redemption. For example, a large commercial bank that acts as the SPDR GLD ETF’s trustee deals with the creation and redemption of gold from its London vaults in blocks of 100,000 shares (10,000 troy ounces). This trustee does not deal directly with the public, so any individual investor wishing to exchange shares for physical gold would have to come to the appropriate arrangements with a broker. In contrast, COMEX Gold futures (100 troy ounces) are available for delivery, by the details of the contract, from an exchange-licensed New York City depository.
There can be costs associated with security, transportation, and insurance whenever you redeem shares and take delivery of physical assets, so be sure to consult an investment professional before doing so.
The information provided will hopefully help answer the question, “Which gold investment is appropriate for me, gold futures or the gold ETF?” While there is a place for ETFs in any investment portfolio, several drawbacks do not make them the first choice for individuals wishing to invest in gold.
When the goal is to simply benefit from a rise or fall in the price of gold, COMEX Gold futures are the logical choice. COMEX Gold futures offer the investor a fast and accurate pricing mechanism, the ability to leverage their trading strategies, and the security of doing business on an exchange that has guaranteed the performance of each of its transactions for over 100 years.
|Contract Name||COMEX Gold futures||COMEX miNY Gold futures|
|Venue||CME Globex, CME ClearPort, Open Outcry (New York)||CME Globex|
(All Times are New York
CME Globex Sunday – Friday 6:00 p.m. – 5:15 p.m. (5:00 p.m. – 4:15 p.m. Chicago Time/CT) with a 45-minute break each day beginning at 5:15 p.m. (4:15 p.m. CT)
CME ClearPort: Sunday – Friday 6:00 p.m. – 5:15 p.m. (5:00 p.m. – 4:15 p.m. CT) with a 45-minute break each day beginning at 5:15 p.m. (4:15 p.m. CT)
Open Outcry: Monday – Friday 8:20 a.m. – 1:30 p.m. (7:20 a.m. – 12:30 p.m. CT)
|Delivery may occur on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but not later than the last business day of the current delivery month.|
|Contract Size||100 troy ounces||50 troy ounces|
|Price Quotation||U.S. dollars and cents per troy ounce||U.S. dollars and cents per troy ounce|
|Minimum Fluctuation||$0.10 per troy ounce||$0.25|
|Floating Price||N/A||The floating price for each contract month is equal to the COMEX Gold futures contract’s settlement price for the corresponding contract month on the third last business day of the month prior to the named contract month.|
|Termination of Trading||Trading terminates on the third last business day of the delivery month.||Trading terminates on the third last business day of the month preceding the delivery month.|
|Listed Contracts||Trading is conducted for delivery during the current calendar month; the next two calendar months; any February, April, August, and October falling within a 23-month period; and any June and December falling within a 60-month period beginning with the current month.||Trading is conducted during the same months as the full-sized gold futures contract (GC), except the current month.|
|Delivery Period||Delivery may take place on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but not later than the last business day of the current delivery month.||N/A|
|Grade and Quality |
|Gold delivered under this contract shall assay to a minimum of 995 fineness.||N/A|
|Exchange Rule||These contracts are listed with, and subject to, the rules and regulations of COMEX.||These contracts are listed with, and subject to, the rules and regulations of COMEX.|