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Commodity ETFs – Everything You Need to Know

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Commodity ETFs offer investors one of the easiest ways to invest in the commodity market – either in individual commodities or in commodity indexes. This is good news because investing directly in commodities can be a complex, time consuming process.

What are commodities?

Commodities are physical goods, either naturally occurring materials or agricultural products. The commodities that are traded are widely used and fungible – in other words one unit is more or less the same as another. They are also known as resources or basic materials.

The commodity market is usually divided into the following three categories:

  • Metals, consisting of both precious metals like silver and gold, and base metals like iron, copper and zinc.
  • Energy commodities include oil, gas and coal.
  • Agricultural commodities include livestock like cattle, and soft commodities like cotton, corn and wheat.

Commodities are a distinct asset class that can be used to diversify a portfolio of stocks and bonds. Commodity prices have relatively low correlation with other assets and may act as a hedge against inflation.

What are Commodity ETFs?

Exchange traded funds are listed trusts that own a basket of other securities. They can be traded just like stocks and allow investors to buy a portfolio of assets with just one trade. This is both cheaper and easier than building a portfolio from scratch. You can learn more about ETFs here.

Some commodity ETFs invest in commodity indexes in the same way that stock ETFs invest in stock index. However, some of the most widely traded commodity ETFs invest in just one commodity.

Physical commodities vs commodity futures

Investing in commodities introduces new challenges. Financial instruments like stock and bonds present few logistical challenges as they exist only in digital or paper form. Trading and investing in commodities introduce real-world issues like transport, storage, security and insurance.

These logistical challenges mean most commodities trade takes place in the futures market. Futures contracts represent an obligation to buy or sell an asset on a future date. In practice though, futures contracts can be closed out before expiry, or rolled into a contract with an expiry date further into the future.

Some ETFs hold physical commodities while others hold futures contracts or a combination of the two.

Backwardation and negative roll yield

When investors use futures contracts to gain exposure to a commodity, a phenomenon called backwardation can occur. This happens when investors switch from contracts expiring soon into contracts expiring at a later date. The result is that the near contracts trade at a discount to the underlying asset, while the longer-term contracts trade at a premium. Constantly rolling a position from one contract to the next can become a costly exercise. This is known as negative roll yield.

If an ETF uses futures contracts for exposure to commodities, backwardation can be a drag on performance. If you plan to invest in commodity ETFs, you should take this into account. Look at how the price of the ETF tracks the index or underlying commodity to see what the likely ‘cost’ of backwardation is.

ETNs vs ETFs

Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) are often used interchangeably, and for the most part serve the same function. Both trade on stock exchanges like shares. However, there is an important distinction.

ETFs are trusts that hold a portfolio of assets, or in the case of commodity ETFs, sometimes just one asset. ETNs are a type of structured product, similar to debt instruments and bonds. They are not backed by assets, but by the institution that issues them. ETN issuers hedge their obligations by holding assets on their own balance sheet.

The advantage of ETNs is that there is no tracking error as the price simply tracks an index. The disadvantage is that ETNs carry counterparty risk. If the issuer was to become insolvent, they may be unable to honor their obligations. In most cases the issuers are large institutions with strong balance sheets. However, it is worth considering the financial strength of the issuer.

Examples of commodity ETFs

The largest commodity ETFs are single commodity funds that track the price of gold, silver and crude oil. In fact, of the 10 largest US listed commodity funds five track the gold price, two track the oil price, one tracks silver and one tracks platinum.

The largest of these is the SPDR Gold Trust (GLD) which is managed by State Street. This fund holds physical gold worth in excess of $70 billion dollars.

The largest commodity ETF that tracks an index of assets is the Invesco Optimum Yield Diversified Commodity fund (PDBC). This fund invests in futures contracts on 17 different commodities. It is actively managed to reduce the effects of negative roll yield.

The largest oil fund is the United States Oil Fund (USO) managed by USCF. This fund tracks the price of Sweet Light Crude Oil using futures contracts.

For investors looking for exposure to agricultural commodities, iPath runs an ETN (COW) that tracks an index of live cattle and hogs, and the Invesco DB Agriculture Fund (DBA) invests in a wider range of agricultural products.

Advantages of commodity ETFs

  • Commodity ETFs are the easiest way to own commodities.
  • Commodity ETFs are typically cheaper than commodity mutual funds.
  • Commodities have a relatively low correlation with other asset classes and can therefore diversify a portfolio and reduce overall volatility.
  • Commodities tend to act as a hedge against inflation.

 Disadvantages of commodity ETFs

  • Investing in physical commodities can be expensive. These costs can act as a drag on performance.
  • ETFs that invest in commodity futures may suffer from negative roll yield.
  • Commodity prices are more volatile than other asset classes. An allocation to commodities should be limited in size to offer effective diversification benefits.
  • ETNs carry counterparty risk.

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Commodity ETFs - Everything You Need to Know

 

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Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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