Commodity ETFs: It Pays to Do the Research

Just because an investment drops in value doesn't mean it's a bargain. That's a lesson many investors learned the hard way back in April 2020 when they scooped up shares of a popular oil exchange-traded fund (ETF) after the spot price of crude dropped below zero.

Contrary to some investors' expectations, the ETF continued to struggle for several days after the price of oil recovered. So where did investors go wrong? What they thought was a fund that tracked the spot price of West Texas Intermediate crude—the U.S. benchmark for oil—was in fact a fund that tracked the benchmark's futures contracts, which can produce very different returns.

With any fund, but especially those that track commodities, it's important to understand the fund's strategy before you buy. Here are three questions to ask when researching commodity ETFs for your portfolio.

Some precious-metal ETFs actually purchase the physical commodities—such as bars of gold or silver—and warehouse them in secure vaults. These ETFs tend to closely track the spot price of the commodity in question because the metals can be retrieved and sold on the spot market at any time.

However, most commodities—including livestock, oil, and wheat—are too costly or cumbersome for an ETF to transport and store. Instead, ETFs typically invest in these commodities via futures contracts, which are agreements to buy a commodity on a future date for a specified price, with the intention of selling the contract before it expires rather than taking possession of the commodity in question.

As a result, ETF managers must regularly sell expiring contracts and purchase new ones with later expiration dates—with two potential consequences:

• When contracts approaching expiration have higher prices than those with expiration dates further out, ETFs are effectively selling high and buying low with every contract rollover—a condition known as backwardation. This happens when the current demand for a commodity is higher than what investors expect it to be in the future, relative to its supply.
• Conversely, when contracts approaching expiration have lower prices than those with expiration dates further out, ETFs are effectively selling low and buying high with every contract rollover—a condition known as contango. This happens when the current demand for a commodity is lower than investors expect it to be in the future, relative to its supply.

While contango obviously isn't ideal, fund managers often invest in futures contracts of various durations to help mitigate its effects.

Commodity ETFs are notoriously volatile because of the supply-and-demand characteristics of their underlying holdings, which can be dramatically impacted by certain events. Unseasonably cold or wet weather, for example, can be catastrophic to some agricultural commodities, while the Organization of the Petroleum Exporting Countries (OPEC) can unduly influence oil prices.

One possible solution to this potential problem is to consider ETFs that track a broadly diversified commodity index. That said, the degree of diversification will vary by index. For example, 61.5% of the S&P GSCI Commodity Index is allocated to the more-volatile energy sector,¹ while the Bloomberg Commodity Index's allocation is roughly half that, at 29.9%.²

The complexities of commodity ETFs can also create unusual tax issues. Funds with direct ownership of precious metals, for example, are taxed as collectibles under U.S. rules. Depending on your income tax bracket, the tax bill for this investment may be higher than the long-term capital gains rate or even your ordinary income tax rate.

Funds that invest in futures and other derivatives contracts, on the other hand, may be structured as partnerships, meaning you get a K-1 tax form at the end of the year instead of the typical 1099. To avoid the complications and added expense K-1s can create at tax time, some newer funds pass their investments through an offshore entity, which allows the fund to be taxed like a traditional mutual fund. However, it's important to note that such funds may be actively managed and may offer less visibility into their underlying holdings.

Investing in commodity ETFs can be a low-cost way to add diversification and inflation protection to your long-term portfolio. However, if you're looking to make shorter-term tactical moves, be sure you understand how the ETF you're considering is constructed, since a fund's volatility, in particular, can have an outsize impact on your short-term prospects.