Physical Or Futures?

October 11, 2011

One of the major misunderstandings many investors have about commodities ETFs is how futures-based ETFs work.

Countless investors have been baffled about how their natural gas ETF could have lost so much money while the spot prices of natural gas rose.

We’ve told the contango story before, but it can’t be told often enough. For most commodities, it’s impossible to actually invest in the spot price. After all, it is simply impractical for an ETF to hold physical natural gas or the countless bales of wheat it would take to satisfy investor interest. Thus, investors buy futures contracts or, these days, ETFs that are based on futures.

Futures-based ETFs work by selling off old futures contracts as they get close to expiration and buying new ones. If the new contracts are more expensive than the old ones, that’s called contango, which costs you money. If the new contracts are less expensive, you make money. If you’re curious about whether your commodity of choice is currently in contango, check out our affiliate’s weekly Contango Watch.

That said, if you’re interested in precious metals, there are both physical and futures-based options. Unsurprisingly, the difference can be pretty significant.

I’ve compared the physically backed SPDR Gold Shares (NYSEArca: GLD) to the futures-based PowerShares DB Gold Fund (NYSEArca: DGL). DGL tracks the DBIQ Optimum Yield Gold Index Excess Return Index, which attempts to maximize roll yield.

GLD vs. DGL Jan 2007 - YTD 2011

While an index that tries to optimize roll yield is better than one that simply rolls into the next month’s futures contract, gold is firmly in contango these days, so investors will lose some of their returns regardless of whether DB chooses the near-month contract or a contract that is three months out.

The returns since DGL’s inception confirm this point—GLD has outperformed DGL by nearly 20 percent since January 2007.

It’s the same story in platinum. I compared the ETFS Physical Platinum ETF (NYSEArca: PPLT) to the iPath DJ-UBS Platinum Subindex Total Return ETN (NYSEArca: PGM). Depending on your start date, you’ll either see a big gap or an indiscernible gap between the two funds, with contango being the driving force. The chart from January 2010 through today shows the impact of contango quite nicely.

Contango Impact on PPLT vs. PGM: 1/10 - YTD 2011

The futures-based funds aren’t necessarily bad funds, they just happen to be based on commodities that are currently in contango. Were the commodities to go into backwardation—when prices on the futures curve grow cheaper over time—the futures-based funds would outperform their physical counterparts.

Market volatility isn’t going away anytime soon, and precious metals have fallen from their August highs, so it may not be a bad time to get back into precious metals. Whether that means a physical or a futures-based fund is up to you.

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