Commodity ETFs can be smart diversification tools. However, there are some unique risks with these funds that investors should understand before buying them.
Here we outline how commodity ETFs work, as well as the pros and cons of investing in these funds.
What Is a Commodity ETF?
A commodity ETF is an exchange-traded fund that seeks to track the price movement of an underlying commodity or index. Commodity ETFs may accomplish this goal directly by holding the physical commodity, or they may track the benchmark asset’s price indirectly by using derivatives, such as futures or options contracts.
Some commodity ETFs are equity-based, which means they invest in companies involved in natural resources or the mining industry. The most popular commodity ETFs, as measured by assets under management, track the price of a single commodity, such as crude oil, gold, silver or agricultural products, or they track an index representing a basket of many commodities.
How Do Commodity ETFs Work?
Conventional ETFs typically track the performance of an index of securities, such as stocks or bonds. However, the typical commodity ETF tracks the performance of a single commodity or a basket of commodities by using futures or asset-backed contracts. This means commodity ETF investors don’t own the physical asset but instead own a fund made up of derivatives.
Some commodity ETFs do hold a physical asset. Although the ETF investor still doesn’t hold the physical asset, they are given direct exposure to its price. For example, the largest gold commodity ETF by assets under management is the SPDR Gold Trust (GLD), which tracks the gold spot price, less expenses and liabilities, using gold bars held in London vaults.
Other commodity ETFs may create their own benchmark index, which may include a certain group of commodities, such as precious metals, agricultural products, or natural resources. Investors may also gain more diversified access to a wide range of commodities by investing in a “broad basket” commodity ETF.
Types of Commodity ETFs
The main types of commodity ETFs can be broken down into categories based on how they provide investors with exposure to the benchmark asset. These commodity ETF types include physically backed funds, futures-based funds, equity-based funds, and ETNs.
The main types of commodity ETFs include:
- Physically backed commodity ETFs: directly hold commodities stored in a physical location. Typical examples include commodities, gold, silver or platinum, which can be stored for a long period of time, but not for commodities like corn, which cannot be stored for long periods of time. ETFs with physical holdings typically incur transportation, rent and security costs. On the other hand, these types of funds aren't exposed to the futures curve, which can result in significant rollover costs for futures-based ETFs.
- Futures-based commodity ETFs: buy futures, forwards, or swap contracts on the benchmark commodity. Futures-based commodity ETFs tend to be the most common, but investors should remain aware of “roll costs,” which occur when rolling short-term contracts into longer ones. These costs can cause tracking errors over time.
- Equity-based commodity ETFs: hold stocks of companies that are associated with the mining and production or transport of commodities.
- Commodity ETNs: are exchange-traded securities like ETFs, but ETNs use debt contracts issued by a financial institution that agrees to pay interest that is linked to the returns of a specified commodity.
Pros and Cons of Commodity ETFs
Commodity ETFs can be good tools for diversifying a portfolio; however, they can present significant risks, such as short-term price volatility. Investors are wise to learn the benefits and risks of commodity ETFs before investing in them.
Pros of Commodity ETFs
- Diversification: Commodity prices tend to have a low correlation with prices of the primary investment assets. For example, in 2022, when both stocks and bonds were negative, commodities were generally positive. Investors can gain diversified exposure to commodities through a broad basket ETF like the Invesco DB Commodity Index Tracking Fund (DBC), which tracks an index of 14 commodities.
- Inflation hedge: When the price of goods and services are rising, commodity prices are also generally rising.
- Convenience: Investors can gain exposure to the price movement of commodities without having to physically hold the assets or buy futures contracts.
Cons of Commodity ETFs
- Price volatility: Commodity prices can have wide and sudden swings that result from unpredictable events, such as severe weather or geopolitical conflicts.
- Tracking error: ETFs that buy derivatives, such as futures contracts, may not accurately track their benchmark indexes over time.
- Tax differences: Some commodity ETFs, such as those that hold precious metals directly, have higher capital gains tax rates because tax rules treat these ETFs as collectibles.
Commodity ETFs provide exposure to a single commodity, such as crude oil or gold, either directly by holding the physical commodity or indirectly by investing in derivatives. Some commodity ETFs may also invest in stocks of companies involved in the production or transportation of commodities or in natural resources.
Because of the potential volatility of commodity prices, investors should use caution when investing in these unique ETFs. For example, when investors use commodity ETFs for diversification, they typically won’t allocate more than 5%-10% of the portfolio to these funds.