While the price of oil, gold, cotton, soybeans and cattle make headlines every day, few investors have the money, skill or storage space to invest directly in physical commodities. After all, where are you going to store 10,000 gold ingots or 1,000 head of cattle as you wait for prices to rise? Fortunately, exchange-traded funds (ETFs) that invest in commodities offer a convenient, low cost way to access the commodities markets. Before you invest in commodity ETFs, there are a variety of things to consider as you evaluate the multitude of offerings.

What Does it Buy?

There are two primary investment methodologies for commodity ETFs. In one methodology, the ETF invests directly in physical commodities (such as the previously mentioned gold and cattle). In the other, the ETF buys derivatives (futures contracts and/or swaps). Due to the challenges associated with holding, trading and delivering vast quantities of physical commodities, many ETFs opt to use derivatives. This not only eliminates the logistical challenges and their associated expenses, it also reduces tracking errors against the benchmark. The speed and convenience of trading contracts over physical commodities simply makes it easier for ETF portfolio managers to keep pace with the changing marketplace.

On the other hand, trading derivatives comes with challenges of its own. Unlike an ingot of gold, which can sit in a vault forever, futures contracts expire. The cost of replacing them can be greater than the previous acquisition cost, resulting in a condition referred to as “contango.” This cost, of course, reduces investment returns. The reverse is also true. In a condition referred to as “backwardation,” there may be no cost to purchase the next contract. In some instances, investors may even be paid to make the purchase. (For even more gold investment options, see Investopedia's article, "The Gold Showdown: ETFs vs. Futures.")

Understanding these differences relates to more than just a few basis points of investment returns. While it can be argued that the costs associated with contango are akin to the costs associated with storage of physical commodities, and that derivatives-based ETFs generally have a performance advantage, it must be remembered that investors in derivatives-based ETFs have no claim on any physical commodity. Derivatives are contracts that rely on the creditworthiness of the contract issuer. If that issuer fails, the ETF investors do have an ingot of gold or a barrel of oil that they can sell to recoup the cost of their investment. While this is simply one of the risks associated with commodity ETFs, it is a risk worth considering. Investors who would prefer to be able to lay claim to a physical asset should a worst-case scenario unfold may find greater peace of mind by investing in ETFs that hold such assets.

There may also be another peace of mind element associated with physical commodities. Investors who prefer to invest only in assets that they truly understand may feel better owning their share of a herd of cattle as opposed to their share of a contract in contango. That noted, this too comes with complications, as certain investment strategies may be difficult or impossible to find if one limits oneself to strategies that hold only physical commodities. A further note worth mentioning is that ETFs that hold physical commodities often loan those assets to other investors (such as hedge funds), introducing yet another complex element of risk.

What Does it Offer?

Whether they hold contracts or physical commodities, ETFs offer various degrees of portfolio concentration. Some invest only in a single commodity while others hold a variety of commodities. The four major areas of commodity investment include energy, agriculture, precious metals and industrial metals. Within each of those categories are a host of additional offerings.

Energy offers exposure to crude oil, heating oil, gasoline, and natural gas for example. Various ETFs provide strategies either focused on a single type of energy or a combination of sources. Agriculture is similar, with cotton, coffee, cattle, gain, orange juice and more. Precious metals can include gold, silver, platinum and palladium, while industrial commodities include aluminum, nickel, copper, lead and tin.

A more concentrated portfolio, such as one that specializes in gold, can provide an opportunity to generate greater returns. It also exposes an investor’s portfolio to greater risk, as a collapse in the price of gold will have a seriously detrimental impact on the portfolio that would be felt in a broad-based commodities portfolio that included exposure to other precious metals. A portfolio that also included energy, agriculture or industrial metals would provide even further diversification.

While an investors seeking to profit from daily price fluctuations in a single commodity may be perfectly happy with the risks associated with a concentrated portfolio, another investor may not be as willing to take the risks. Considering the argument that exposure to commodities is good because it offers assets that are less correlated to the movements of the traditional stock and bonds markets, long-term investors may choose an a allocation to a broad-based commodity ETF instead of a more focused portfolio.

How Does it Stack Up Against the Competition?

While commodity ETFs enable investors to access unique investment opportunities, investors need to look at two key factors that apply to all ETFs: fees and performance. Every penny spent in fees is a penny that detracts from investment returns. Investors should always purchase the least expensive investment that meets personal needs. Performance, of course, should be factored into that equation. A poor-performing ETF with low expense may be a worse choice than a top-performing fund that has high expenses. A careful review of expense and performance numbers is a key step in evaluating a commodity ETF, and most other investments as well. A few minutes spent researching the ETF’s benchmark is also a worthwhile endeavor. Understanding the benchmark enables investors to evaluate an ETF's appropriateness. For example, a niche ETF that invests in a tiny subsector of the commodity markets may look fantastic if its benchmark is a broad market index, but may look less impressive if the benchmark is specific to its niche. Similarly, if risk management is a concern, benchmark construction methodologies are worth considering. Knowing whether an ETF benchmark is market-capitalization weighted, equally weighted or based on another methodology can provide insight into portfolio risk.

Benefits and Risks

Commodity ETFs offer a variety of investment strategies and exposures but also come with unique risks. The price of physical commodities (known as the spot price) may or may be reflected in the price of a commodity ETF due to contango, ETF investment strategy and other factors. As with all investments, investors should spend some time learn about the nuances of commodity ETFs and determining the exact role they will play in a portfolio before investing in them.

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