ETFs vs Futures: How do you choose?

An individual who wants a diversified investment portfolio has a wide range of options to choose from. Your Central Provident Fund account balance will give you a predictable and secure return, but for those Singaporeans looking for other investment avenues, exchange traded funds (ETFs) and futures contracts could offer attractive alternatives.

What exactly are ETFs and futures contracts and what are the risks that they carry? Should individuals opt for these investments?

 

Understanding ETFs

This financial instrument is suitable for those investors who want to put their money into a certain commodity or into a stock index, but do not want the attendant problems that could accompany a direct investment. For example, an individual may hold the view that the price of gold would rise in the immediate future. One option is to purchase physical gold, store it till the price increases, and then sell it to realise a profit.

But this method of investment could throw up several difficulties. It could also prove to involve a great deal of expenditure. The buyer would need to store the physical gold in a secure location and insure it. It would also be necessary to verify that the metal was of the specified purity. It is simply not possible for an individual investor who has a limited amount of funds to bear the expenses that these requirements involve.

Fortunately, you can benefit from the rising price of gold by investing in an ETF. This is a marketable security that tracks an index or a commodity like gold. An ETF pools the resources of thousands of investors and deploys the money it collects in the targeted investment. In the normal course, an ETF will have fees and charges that are lower than those charged by other unit trusts. This is because the funds it collects are not actively managed. Instead, an ETF tries to replicate the returns of a specific commodity like gold or an index like the Straits Times Index.

 

SPDR Gold Shares

Source: Shutterstock

Marketed by State Street Global Advisors, SPDR Gold Shares is an ETF that is traded on SGX. The investment objective is to have the shares track the price of gold bullion.

How has this ETF performed?

Source – SPDR Fact Sheet as of February 28, 2017

The ETF uses the London Bullion Market’s LMBA gold price as the reference benchmark for calculating the Net Asset Value (NAV). SPDR Gold Shares incurs a recurring fixed expense of 0.40% per year of the daily NAV. Gold bullion is held by the trust and is sold to meet the trust expenses when required.

 

What are futures contracts?

A futures contract is quite different from an ETF. An ETF is essentially a unit trust that pools the money that investors put up and deploys it in a specific manner to earn a return. A futures contract, on the other hand, is a legally enforceable agreement to buy or sell an underlying asset at a certain pre-decided price on a fixed date in the future.

An individual who enters into a futures contract is obligated to deliver the underlying asset or to settle the difference in price in cash. Leverage is commonly used in futures contracts. An individual who opens a futures contract is required to put down a deposit that is a percentage of the total value of the asset that is being traded. This initial margin is usually between 5% and 10% of the value of the futures contract.

This leverage can work to significantly enhance the returns that an investor can make as you can enter into a contract that could be for 10 or even 20 times the value of the initial margin that you have placed with your broker. Of course, leverage could work to your disadvantage too. If the futures trade goes in the opposite direction, your losses will be magnified.

PhillipFutures offers you the opportunity to trade in over 300 products on 24 exchanges across the world. Futures contracts are available for precious metals like gold, silver, platinum, and palladium. It is also possible to enter into trades for several other metals including copper, aluminium, lead, nickel, and tin.

 

Which type of investment is preferable?

Conservative investors who have a low appetite for risk should not deploy their funds in futures trading. The risks are high and it is quite possible that you will lose a substantial portion or even the entire initial margin that you put up.

ETFs are a much safer option. They do not require your active involvement and it is generally quite safe to invest in an ETF and monitor the value of your investment only at periodic intervals.

You could buy into Nikko AM Singapore STI ETF. This is an exchange-traded fund that seeks to replicate the performance of Singapore’s Straits Times Index. If the index registers a gain, you will automatically benefit.

You should enter into futures trading only if you have specific knowledge about the underlying asset of the futures contract. This will give you an advantage in deciding upon your trading strategy. But regardless of the level of your expertise, it is still possible to lose a substantial portion of your investment if you are not careful.

(By Ravinder Kapur)

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