Key Takeaways
- Commodities are basic goods used as inputs in the economy and can serve as a hedge against inflation.
- Commodities often have a negative correlation with stocks and bonds, providing diversification benefits.
- Investing in commodities may be challenging for individual investors due to storage and shipping constraints.
- Commodities offer exposure to different economic cycles and can be traded through futures contracts or commodity-focused funds.
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Commodities are raw materials or primary agricultural products that can be bought and sold. They provide investment opportunities and may be used as a store of value and a hedge against inflation. Commodities are an asset class typically negatively correlated with other asset classes, such as stocks and bonds. When stocks and bonds decrease in value, commodities will increase, and vice versa.
Commodities include assets like oil, natural gas, precious metals, and agricultural products, which are fundamental to the global economy. They offer investors a way to diversify their portfolios. Commodity ETFs give ordinary investors easy and inexpensive access to various commodities markets.
Benefits of Investing in Commodity ETFs
Commodity ETFs enable investors to gain exposure to individual commodities or baskets of commodities in a simple, relatively low-risk, and cost-effective manner. Numerous ETFs track commodities, including base metals, precious metals, energy, and agricultural goods, with which investors can design their ideal commodity exposure.
A commodity ETF usually focuses on a single commodity, holding it in physical storage or on investments in futures contracts. Other commodity ETFs track the performance of a commodity index that includes dozens of individual commodities through a combination of physical storage and derivatives positions.
Important
Investors are not usually permitted to make automatic investments or withdrawals into or out of ETFs.
Different Categories of Commodity ETFs
Four different types of commodity ETFs can meet an individual investor’s investment goals, risk tolerance, and cost tolerance:
Equity Funds
Equity-based commodity ETFs hold stock in companies that produce, transport, and store commodities. An equity-based commodity ETF exposes investors to multiple companies or specific sectors but in a simple, inexpensive manner rather than buying the underlying company.
Equity funds can be a safer way to gain exposure, minimizing the risks associated with physical and futures commodity ETFs. This passive investing and economies of scale may also provide lower expense ratios. However, investing in equity funds adds a layer between the investor and the commodity.
Exchange-Traded Notes (ETNs)
An exchange-traded note (ETN) is a debt instrument issued by a bank. It is an unsecured debt that has a maturity date and is backed by the issuer. ETNs seek to match the returns of an underlying asset, and they do so by employing different strategies, including buying stocks, bonds, and options.
The advantages of ETNs are that there is no tracking error between the ETN and the asset it is tracking, and they receive better tax treatment because an investor only pays regular capital gains when sold. The main risk involved with ETNs is the credit quality of the issuing institution.
Physically Backed Funds
Physically backed ETFs hold physical commodities and are limited to precious metals. The advantage of a physical ETF is that it owns and has possession of the commodity. This removes both tracking and counterparty risk. Tracking risk occurs when the ETF fails to provide the same returns as the asset it is supposed to track. Counterparty risk is the risk that the seller does not actually deliver the commodity as promised.
The disadvantage of physically backed ETFs is the costs of delivering, holding, storing, and insuring physical commodities. The avoidance of these costs is what often pushes investors to buy commodity futures instead. Physical precious metal ETFs are taxed as collectibles, which means capital gains are taxed at the investor’s marginal tax rate. Short-term gains are taxed at ordinary income rates.
Futures-Based Funds
These ETFs build a portfolio of futures, forwards, and swap contracts on the underlying commodities. The advantage of a futures-based ETF is that the ETF is free of the costs of holding and storing the underlying commodity.
Most futures-based commodity ETFs pursue a “front-month” roll strategy where they hold “front-month” futures, or the futures closest to expiration. The ETF must replace those futures before they expire with the second-month (the subsequent month) futures. This strategy closely tracks the current, or spot, price for the commodity. However, the ETF is exposed to “rolling risk” as the expiring front-month contracts are “rolled” into the second-month contracts.
The majority of futures-based commodity ETFs are incorporated as limited partnerships. For tax purposes, 60% of the gains are taxed as long-term capital gains, and the remaining 40% are taxed at the investor’s ordinary tax rate. The LP’s gains are marked to market at the end of the year, which may create a taxable event for an investor, even if they haven’t sold any of their shares in the ETF.
Tip
Investors can harvest tax losses at year-end to then be net against gains. They may then be able to net the two to reduce their taxable income in the following year.
Understanding the Risks of Commodity Investment
Commodity markets are usually in one of two different states: contango or backwardation. When futures are in contango, prices for a particular future are higher in the future than in the present. Futures in backwardation show that prices for a commodity are higher now than in the future. Some commodity ETFs pursue strategies designed to avoid the risks posed by a market that is in contango.
In contango, the rolling risk is “negative,” and a commodity ETF sells lower-priced futures that are expiring and buys higher-priced futures, which is known as “negative roll yield.” The cost of adding higher-priced futures reduces returns and acts as a drag on the ETF, preventing it from accurately tracking the spot price of the commodity. When a futures market is in backwardation, the rolling risk is “positive.” An ETF will be selling higher-priced futures that are expiring and buying lower-priced futures, creating a “positive roll yield.”
Exploring Investment Strategies and Associated Expenses
A laddered strategy uses futures with multiple expiry dates, where not all the futures contracts are replaced simultaneously. An optimized strategy chooses futures contracts that have the mildest contango and the steepest backwardation in an attempt to minimize costs and maximize yields.
Both of these approaches may be suited for long-term risk-averse investors as they reduce costs but at the expense of tracking and potentially benefiting from short-term moves in the price of the underlying commodity. Futures-based commodity ETFs incur higher expenses due to the constant rollover of futures contracts.
ETFs may influence futures prices due to their need to buy or sell large numbers of futures contracts at predictable times, known as a “roll schedule.” This also places the ETFs at the mercy of traders who may bid prices up or down in anticipation of the ETF trade orders. Finally, ETFs may be limited in the size of the commodity positions can take on due to commodity trading regulations.
Examples of Commodity ETFs
Commodity ETFs track a wide range of underlying commodities, some of which include precious metals, oil, and natural gas. Some commodity ETFs track a diversified basket of commodities. Precious metals like gold and silver are popular ETFs. The SPDR Gold Shares and iShares Silver Trust are two of the largest gold and silver ETFs. The SPDR Gold Shares ETF has an expense ratio of 0.40%, and the iShares Silver Trust has an expense ratio of 0.50%.
A commodity ETF can invest in futures contracts of oil and natural gas. The SPDR S&P Oil & Gas Exploration and Production ETF has a diversified portfolio of oil- and gas-producing companies with an annual expense ratio of 0.35%.
Some investors can increase diversification through diversified commodities ETFs. These ETFs, such as the iShares MSCI Agriculture Producers ETF, track the MSCI ACWI Select Agriculture Producers Investable Market Index.
What Affects Commodities for Investment?
Commodities are influenced by many factors, such as weather, labor production, consumer demand, shipping constraints, and government subsidies. However, commodities represent goods with stable and consistent demand.
Do Commodity ETFs Track All Commodities?
ETFs may specialize in certain types of commodities such as cropland. Other ETFs may be further diversified into all major commodity sectors such as energy, metal, or agriculture.
What Happens to Commodity Prices During Inflationary Periods?
Commodities fluctuate in price in movement with inflation, such as farming yields that rely on inputs such as labor and fertilizer that fluctuate in price. Many investors seek investment in gold as a safe haven that protects asset value. During an inflationary period, the U.S. government may keep the Federal Reserve rate low to generate economic growth or a higher oil demand.
The Bottom Line
Commodity ETFs provide commodity exposure for investors to diversify their portfolios. Many different types of commodity ETFs focus on various commodities, use different strategies, and have varying expense ratios. Investment depends on an individual’s goals and risk tolerance. Commodity funds often create benchmark indexes that include only agricultural products, natural resources, or metals. As such, there is often tracking error around broader commodity indexes like the Dow Jones Commodity Index.