Learn: Commodity ETPs

[This article comes from the Learn section of our website]

There are close to 300 commodity ETP listings on the London Stock Exchange. With so many to choose from, it’s obvious there’s investor demand. It also makes understanding how commodity ETPs work all the more important.

For starters, when we talk about commodity ETPs, we’re not talking about ETFs that hold stocks of companies engaged in mining, drilling or agriculture; we’re talking about ETPs that invest directly, or indirectly, in the commodities themselves—corn, gold, wheat, oil and so on.

There are three key factors that should be considered for UK-based investors: exposure, investment strategy and currency.

Exposure

The first step in choosing the right product is determining what type of commodity you want exposure to. Just as there’s a big difference between buying a technology stock or a utility, so too there’s a big difference between buying gold and oil.

And just like you can buy a broad-based index of stocks, you can buy a broad-based commodity product that captures all of the major commodities, in each of the major sectors—agriculture, energy, industrial metals and precious metals. You can also buy ETPs that track just a single commodity, such as gold, crude oil, natural gas or sugar. In between, there are ETPs focused on each individual sector.

Investment Strategy

Once you define your desired exposure, the next step is determining how you want your ETP to track the commodity or basket. This is where it can get a bit complex, because not all commodity ETPs are created equal.

If you’re interested in precious metals or certain industrial metals, you have the opportunity to select an ETP that actually goes out and buys the commodity, and stores it in a vault or warehouse. For many investors, this is the cleanest, most direct way to get commodities exposure; however, there are also products on these metals that track the futures markets.

Outside those few metals, ETPs are forced to track the futures markets. Nobody wants to own a silo full of corn, and storing large quantities of energy commodities like crude oil and natural gas for investment purposes makes little financial sense.

So the futures markets it is—and therein lies another set of decisions to make.

First off, if your ETP is holding a mix of different commodities, how does the index select and weight its commodities? Does the index select its holdings based on liquidity, production or a combination of the two? Does it also weight its commodities by those factors, or does it follow an equal-weighting structure? (For more information, see “Commodity Indices.”)

Or, does the index have a proprietary, or committee-based, selection and weighting scheme like the Rogers International Commodity Index (RICI)?

Beyond the selection and weighting schemes, which contracts will it hold for each commodity? Many indices implement a “front-month” strategy, where they buy the contract for delivery that’s closest to today, and roll into a new contract each month as the held contract nears expiration. This type of strategy often works well for tracking spot prices, but can be troublesome if the cost for the futures contract is continuously more than the spot price. (For more information, see “Contango And Backwardation.”)

There are numerous strategies for solving this problem, with ETPs owning different months and following different roll strategies. Digging deep and understanding these strategies is important, and can have a real impact on your returns.

Currency

Finally, it’s important to be mindful of currency exposure. Commodity futures contracts are generally priced and traded in US dollars. While a wide swath of commodity ETPs are listed on the LSE in US dollars, there are many that are listed in pound sterling.

For ETPs listed in pound sterling, if the product is not currency-hedged, its returns can be impacted by currency fluctuations between the pound sterling relative to the US dollar. You can bet correctly on, say, the price of corn going up, but if the value of the dollar goes down, you could still lose money.

That’s commodities in a nutshell. Commodity ETPs can be a great diversifier and inflation hedge, but it’s important to understand there are big differences between commodities and other asset classes.