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The Differences Between Trading ETFs And Futures

Exchange-traded funds (ETFs) and standardised futures offer individuals interested in the capital markets a variety of trading options. From very short-term scalping opportunities to the execution of hedging strategies, both ETFs and futures are ideal for satisfying nearly any financial objective.

By comparison, ETFs and futures have several key differences that separate them as financial instruments. The official definitions of each:

  • ETF: According to the United States Securities Exchange Commission (SEC), an ETF is an "SEC-registered investment company that offers investors a way to pool their money in a fund that invests in stocks, bonds, or other assets."[1] An ETF combines the features of a mutual fund with the functionality of conventional stock trading.
  • Futures: Standardised futures contracts are classified as financial derivatives. In the words of the SEC, "a futures contract is an agreement to buy or sell a specific quantity of a commodity or financial instrument at a specified price on a particular date in the future."[2] The Commodities Futures Trading Commission (CFTC) is the regulatory body in the United States and presides over several of the largest derivatives markets in the world.

Finding the ideal product in which to invest capital is often determined on a case-by-case basis. While both futures and ETFs are viable methods of participating in the world's financial markets, there are distinct pros and cons to each.


Common Ground

Although there are many technical differences between ETFs and futures, there is also a collection of shared attributes. It is through these common characteristics that both instruments derive value and tradability is determined:

  • Underlying Asset: The valuation of ETF and futures products is based on an underlying asset or collection of assets. Equities indices, commodities, currencies and debt instruments are all addressed. Futures products are considered to be financial derivatives, while ETFs are not—most of the time. Certain ETFs may include derivative products in various quantities, earning the moniker "leveraged ETFs."
  • Long/Short: Traders and investors have the ability to profit from being either long or short the market. This flexibility enables participants to benefit from selling high and buying low as well as buying low and selling high.
  • Leverage: Broker-defined margin requirements differ facing ETFs and futures, but risk capital may be leveraged in the trade of each product.
  • Traded Digitally: The markets of futures and ETFs are accessed almost exclusively via online trading platforms.

Over time, the demand for ETFs and futures has grown exponentially. Featuring participants from locales around the world, the size and scope of each market is extensive:

  • ETF: Since their inception in 1993, ETFs have exploded in popularity. With products based on nearly every asset class, the global market includes more than 5,000 ETF offerings worth an estimated US$3 trillion.[3]
  • Futures: Standardised futures contracts remain the global benchmark for derivative products. For the year 2017, 14.8 billion futures contracts changed hands worldwide. The CME Group led all exchanges with more than four billion contracts traded.[4]

ETFs and futures offer active traders myriad opportunities to sustain profit on a day-to-day basis. Featuring robust liquidity and inherent volatility, both instruments are well-suited for the active trader.

Nonetheless, each has several advantages and disadvantages to its utilisation. The responsibility falls upon the trader to determine which is the best fit in relation to available resources and market-related goals.

Market Volatility And Liquidity

For active traders, consistent volatility and liquidity are desirable characteristics for a target instrument. Assorted ETF and futures listings exhibit unique levels of each on a product-by-product basis.

ETF volatility has been studied in-depth in comparison to the related underlying basket of stocks or commodities. Reports from the SEC have shown equity ETF products to have a greater turnover and tighter spreads than the individual stocks they are comprised of.[5] The discrepancy is due in large part to the presence of high-frequency trading practices boosting volumes.

However, in comparison to the futures markets, ETFs exhibit lower degrees of periodic pricing volatility. Futures have several unique characteristics that enhance market turbulence:

  • Rollover: The expiration of an existing futures contract can spike pricing volatility. ETFs do not expire, thus there's no rollover period for investors to navigate.
  • Direct Pricing: The value of a futures contract is directly related to that of the underlying asset. For instance, if the price of gold rises on spot markets, the value of gold futures jumps. Conversely, an ETF's value depends upon a collection of assets. Even though the price of gold may rise, the gold ETF's value may vary. External factors such as corporate earnings or waning interest in the ETF product itself may limit returns.
  • Highly Leveraged: The underlying assets of futures contracts are highly leveraged. Required margins are set by each exchange, typically between 5-15% of the total contract value.[6] Like traditional stocks, margin trading for ETFs is a standard 50%.

In addition to pricing volatility, a robust depth-of-market ensures that trades are executed efficiently and slippage is minimised. Futures regularly exhibit high degrees of turnover, many times those of popular corresponding ETFs:[7]

Asset Average Daily Volume (USD, Billions)
E-mini S&P 500 192.0
SPDR S&P 500 (SPY) 19.6
Crude Oil 62.0
United States Oil Fund (USO) 0.4
10-Year T-Note 146.0
iShares Barclays 7-10 Year Note (IEF) 0.22
Gold Futures 28.9
SPDR Gold Shares (GLD) 1.09
Euro FX 27.1
Guggenheim Euro Trust (FXE) 1.1

For the world's most popular products, futures offer deeper markets and greater average daily traded volumes than the corresponding ETF. Higher levels of participation ensure that orders are executed with minimal slippage and tighter bid/ask spreads.

Also, futures markets are open for trade electronically nearly 24 hours a day, five days a week. ETFs offer limited market hours that typically correspond to the related equities markets.

Taxes And Fees

An important part of any trader's approach to the markets is accounting for taxes and fees. To minimise sunk costs, the elimination of any undue management fees, commissions and tax liabilities is a good way to streamline the cost structure of a trading operation.

In terms of fees and commissions, ETFs and futures have unique characteristics:

  • Management Fees: ETFs typically adhere to a 0.44% annual expense ratio.[8] Futures traders avoid these fees unless participating in a managed-futures program.
  • Commissions: Because ETFs trade in the same fashion as stocks, they are subject to brokerage commissions when buying or selling. Futures are also subject to brokerage commissions and all-in round turn pricing may vary significantly from broker to broker.

Tax liabilities are a big issue for all traders, large and small. Tax rates on futures and ETFs will vary depending upon the trader, country, underlying asset and holding period. The following are a few broad tax guidelines for trading ETF and futures products:

  • ETF: Country of issue is extremely important when buying and selling ETF products. Capital gains tax will vary considerably depending upon country. For instance, ETFs in the U.K. may be taxed at a capital gains rate of 18% or 28%.[9] Other countries may have a greater or lessened tax structure.
  • Futures: Tax laws associated with futures trading can be extremely complex to decipher. Rates vary wildly and they depend upon the frequency of trade, whether it is speculative in nature and the distinct rules of the local municipality. In the U.S., futures are taxed at a 60/40 rate, which ensures a maximum capital gains tax of 23%.[10] Again, this value may vary significantly from country to country.

In most cases, the fees and commissions associated with futures trading are less than those of ETFs. However, it is important to perform the necessary due diligence to identify local tax liabilities and satisfy them accordingly.

Summary

Selecting a viable avenue for trade can be a challenging endeavour. Futures offer traders enhanced volatility, market liquidity and the availability of extensive leverage. ETFs provide easy market access for retail traders, a professionally managed fund and an ideal instrument for long-term investiture.

Ultimately, deciding on an ideal financial vehicle is the responsibility of the trader. Properly aligning available resources with trade-related goals is the key to selecting a market or product that gives one the best opportunity of achieving success.