ETFs | December 20, 2019

The Beginner’s Guide to Commodity ETFs

Key Points

  • Commodity ETFs can help provide relatively low-cost access to an asset class that's otherwise difficult to invest in.

  • While commodities can be useful as a hedge against inflation, they generally shouldn't make up a very large portion of your assets—typically no more than 5% to 10% for most investors. 

Exchange-traded funds (ETFs) can provide relatively low-cost access to asset classes such as commodities—physical goods such as precious metals, oil and agricultural products—that may be difficult to invest in otherwise.

Some commodity ETFs track single products such as crude oil or gold. Another popular choice (especially for investors new to commodities) are diversified commodity index ETFs, which are designed to provide exposure to a wide variety of commodities in a single investment.

Before taking a closer look at how such ETFs work, it’s worth noting a few points.

First, while commodities can be useful for diversification and as a hedge against inflation, most investors should limit their exposure to them to no more than 5%–10% of their portfolios. More than that could mean extra risk.

Second, commodity ETFs aren’t like other ETFs, and the differences can impact performance, as we’ll see below.

How is a commodity ETF structured?

Most investors are familiar with stock index ETFs, which are portfolios of stocks designed to track the performance of particular indexes. Typically a commodity ETF will be structured in one of three ways.

  • The simplest structure buys and stores the physical commodity itself. These are technically trusts that use their assets to buy gold bullion to store in bank vaults.
  • Some ETFs primarily hold stocks of commodity-producing companies, such as gold-mining or oil-drilling firms. While the performance of such companies does depend somewhat on the price of the commodity, these funds tend to perform more in line with other stock ETFs than with commodity prices. As a result, investors may not receive the sort of diversification benefit a true commodity ETF would provide but they do gain equity exposure with a link to commodities.
  • Some ETFs hold commodities futures contracts, which are agreements to deliver a commodity at a certain date in the future for a specific price. Futures contracts trade on exchanges, similar to stocks and bonds, and don't require storage like a physical commodity does. Because futures contracts expire, funds that hold such contracts have to decide whether to "roll" an expiring contract in exchange for another contract with a later expiry date.
  • Some commodity ETFs are “technically active”. From a legal perspective, these funds are active ETFs. However, their underlying goal is to match the returns of a commodity futures index. They achieve this goal by holding some of their assets in an offshore subsidiary (typically in the Cayman Islands), and that subsidiary holds the commodity futures contracts. In this way, the fund can deliver returns that are similar to other commodity futures based ETFs, but critically they do not issue a K-1 at tax time (unlike other futures-based ETFs).

 

Understanding commodity ETF pricing

Investors who buy ETFs that use commodity futures contracts are sometimes surprised to see that the ETF does not move in lockstep with the price of the commodity. This is because of a phenomenon called contango.

Contango is when the futures price of a commodity is higher than the spot price, suggesting investors believe the spot price will rise going forward and are therefore willing to pay more for a future contract today. For example, say oil is trading at $70 per barrel today (the spot price). Investors may be so concerned about higher prices in the future that they're willing to pay $72 per barrel now for a contract that promises to deliver oil one month from today. When the future price is above the spot price, that's contango. (The opposite situation, where the future price is below the spot price, is called backwardation.)

If the market for a particular commodity suffers from strong, persistent contango, an ETF that buys futures contracts on that commodity will perform worse than the spot price of the commodity itself. If you invest in a fund that always buys one-month oil futures contracts, for instance, and that fund has to pay $2 more than the spot price for them, the fund will essentially lose $2 per barrel each month when they roll their futures contracts. This is because they will have to sell their expiring contracts near the spot price and buy new contracts at a price higher than the spot price.

In addition, if an ETF that buys futures contracts is very large (with assets in the tens of billions of dollars), it might be possible for other investors to trade ahead of the fund when it's time to roll its contracts each month. Such investors might know that the fund is not equipped to take delivery of the commodity, and therefore has to sell billions of dollars worth of expiring contracts and buy billions of dollars worth of contracts for a month in the future. Knowing that a large fund is about to buy a particular futures contract (pushing up its price), these investors could buy the contract ahead of time at the lower price and sell to the ETF at the higher price—in which case investors who own the ETF will see slightly worse performance than they would otherwise.

ETNs are not ETFs

Some investors consider exchange-traded notes (ETNs) alongside ETFs—but they aren’t the same thing and they introduce a different kind of risk.

There are many commodity-based ETNs, tracking everything from broad commodity indexes to individual agricultural products and metals. ETNs offer to deliver the total return on a broad index or individual commodity, but rather than being structured as pools of securities that the fund itself owns, they are instead unsecured bonds (notes) issued by a firm that agrees to deliver the return of the index it tracks.

Because of this, ETN investors need to be aware of the specific terms of the note and the credit risk of the issuer. If the company offering the ETN goes bankrupt, holders of the ETN become creditors of the firm. In fact, when Lehman Brothers went bankrupt in 2008, shareholders of the three Lehman ETNs were left with securities that had become worthless.

Be cautious with ETNs—while they have the advantage of potentially delivering exactly the return of the underlying index with no tracking error, we think the credit risk is not worth shouldering, since similar products are generally available in a non-ETN structure.

How to choose a commodity ETF

While there are a wealth of options, from single-commodity funds to broadly diversified baskets, it's important to look carefully at the fund, including its structure and its underlying index, before investing. Also, for tax reporting purposes, keep in mind that commodity ETFs may generate a schedule K-1 instead of a 1099 tax form.

Here are some steps to consider when deciding on a commodity ETF:

  • Decide which type of commodity ETF suits your needs. For starters, consider the nature of the index. Are you looking for exposure to a single commodity or a broad index? How much exposure to each commodity sector are you looking for?
  • Consider the characteristics of the fund itself. Look for ETFs with low expense ratios and high trading volume relative to other commodity ETFs, and avoid ETFs with extremely small asset bases.
  • Be aware of the difference between a commodity ETF that relies on futures contracts and one that buys and sells at spot prices (look at the fund's prospectus to see what kind it is). The futures fund will do worse when there's contango but better when there's backwardation.
  • Consider owning a fund that has the flexibility to buy futures contracts of various lengths (e.g., one month, three months, six months, 12 months) instead of just the next month, since contango can differ with the length of the contract (this information should be available in the fund’s prospectus under “Principal Investment Strategy.”)
  • Be aware of the potential for institutional investors to trade ahead of individual investors in very large funds and consider funds that are not quite so large in size.
  • As mentioned we generally prefer ETFs over ETNs whenever possible. 

 

Commodities are not for everyone. Carefully consider their particular risks and complexities before making an investment decision. If you decide that you seek the diversification and inflation protection that commodities may offer, an ETF can be a relatively low-cost way to get exposure to this unique asset class.

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