Liquidity and Leverage – ETFs and Futures
Exchange Traded Funds (ETFs) represent an excellent way for investors to gain exposure to the gold price quickly and cheaply. So too does trading in gold futures. Here we look at the difference in the liquidity and leverage available in both the ETF and futures markets, discussing the advantages and disadvantages of each instrument to the investor.
The largest gold ETF in the world is the SPDR Gold Shares (traded on the NYSE under the symbol GLD). This has net assets of around $65 billion, and trades on average 9.5 million shares per day. It is designed to track the price of gold, and each share represents 1/10 of an ounce of gold. So, the trade in SPDR GLD ETFs represent around 950,000 ounces of gold traded every day.
The average daily volume of gold futures contracts traded at New York’s Comex Exchange is around 200,000. This equates to approximately 20 million ounces of gold.
Clearly, the liquidity in gold provided on the futures exchange is far greater than that provided in individual ETFs, and liquidity is a big factor in deciding where to trade. However, with the price of gold trading around $1600, and a futures contract the equivalent to 100 troy ounces of gold, purchasing a single future contract is a financial commitment in around $160,000. A purchase of 1 GLD ETF share is a commitment on around $160 value of gold.
So for retail investors, ETFs give accessibility that the futures market doesn’t, even though the liquidity of the futures market is far greater.
Of course, retail investors can trade in the futures markets despite the underlying commitment to purchase (or sell) a rather large amount of gold, and may choose to do so. The reasons for this are twofold:
Firstly, very few futures contracts are ever settled for the delivery of the physical gold itself. Investors either trade out of a position, or roll over at expiry to the next expiry date. This means that, just like investors in Gold ETFs, very few contracts are ever exercised and gold delivered. In both cases, ETFs and Futures, whilst it is the underlying price of the gold that traders which to have exposure to, it is the price of the financial instrument itself on which the investor capitalises.
Secondly, the futures market offers the opportunity to leverage their investment capital that ETFs don’t. The futures market operates on margin, which is passed down to a broker’s clients. This means that the investor only has to put up a small amount of the actual purchase price of a futures contract, almost as an insurance to provide for the potential daily loss that might be felt from the average daily fluctuation in price of the contract traded. At the time of writing this article, the margin requirements on a single gold futures contract at Comex is $9.11 per ounce as an initial margin, followed by $6.75 per ounce as a maintenance margin. So the total margin payable on a single futures contract is $1,586. For this payment, an investor would have exposure to around $160,000 of gold. If the gold price rises by 10%, then the investor would make a profit of around $16,000.
For the same down payment in the GLD ETF, the investor would be able to buy around 10 shares. Considering a 10% rise in the price of gold, the investor would make a profit of around $160.
The beauty of leverage is the gearing it gives to produce far greater returns than would otherwise be possible.
Of course it is possible to trade ETF shares on margin, but this margin has to be agreed with the broker. Trading in futures gives automatic leverage, though it should be remembered that the effect on profits would be replicated on losses should an investor’s view prove to be wrong.
Whenever trading, in whatever instrument, there will be costs involved. With both ETFs and futures, there will be brokerage fees to pay, and a trading spread between the bid and ask prices. But there are ‘hidden’ costs which all investors should be aware of.
Management of the fund typically costs around 0.4% to 0.5% per annum. This cost has to be paid for, and as no income is generated by holding gold, the manager will need to sell a small portion of the fund’s assets to recoup his fees and administration expenses which might include marketing costs and other general expenses, including the costs of selling the gold needed to recoup management and other fees! Over time, this will erode the value of the fund, and cause what is known as a tracking error. However, the fund manager knows this and will try to make good this error by its trading and investment methodology.
The costs on futures contracts are probably even more opaque, but need to be considered just the same. The first cost is the ‘time premium’. The longer dated the future is, the higher this premium will be. Just like ETF fees may erode ETF values over time, so too does the time value on a future. Immediately before expiry, the time value will be zero.
There will also be a cost to finance the margin, though this can be equated to the cost of holding ETF shares.
Finally if trading futures, there will be a rollover cost when moving from one expiry date to another, if required, that is not applicable to ETF holders.
Both ETFs and futures are tradable by institutional and retail investors. Whilst the liquidity in the futures market is far higher than that in the ETF market, both are perfectly satisfactory for retail investors.
The costs of trading in both markets are comparable, though the leverage available by trading futures gives more bang for your buck. This said, of course, the risks are multiplied accordingly.
The final decision on which market to use to trade or hedge a position will be dictated by investment aims and personal choice. If an investor feels comfortable dealing in ETFs and less so trading in futures, then the ETF market is probably the best place to remain.