Count commodities among the asset classes that exchange traded funds (ETFs) have made more accessible for a wider range of investors. Thanks to the proliferation of ETFs, no longer do investors have to rely on the futures markets, physical ownership of commodities or often high-fee commodity trading advisors (CTA) for exposure to this asset class.

In the U.S., the world's largest ETF market, there are just over 150 commodities exchange traded products (ETPs). That is less than 10% of the total U.S. ETP universe and far less funds than there are representing bonds or stocks. Moreover, the total assets parked in commodities ETFs are small relative to more familiar asset classes such as equities and fixed income.

On any given day in the U.S., there are just about 10 commodities ETPs with over $1 billion in assets under management. However, statistics like that should not diminish the importance of an investment portfolio having at least some commodities exposure. Depending on factors such as the investor's age, objectives and risk tolerance, advisors will often recommend commodities allocations ranging from 2% to 10%.

Before committing capital to commodities ETPs, investors should take the time to understand how these products function. There is not the level of structure uniformity among commodities ETFs as investors find with bond and stock funds. Consider the various commodities ETP structures.

Physical Ownership

Precious metals are the commodities investors most often associated with physical ownership and prior to the advent of ETFs, that mean jewelry or storing bars and coins, most likely at a bank. Products such as the SPDR Gold Shares (GLD) ease the burden of physically owning commodities

Home to $33.6 billion in assets under management is not only the world's largest gold ETF, but also the largest commodities ETF by a wide margin. The ETF is more than four times larger than the iShares Gold Trust (IAU), the second-largest U.S. commodities ETF. Of the 10 largest commodities ETFs trading in the U.S., four are gold or silver funds, including GLD and IAU.

ETFs like GLD and IAU are designed to reflect the price action in spot gold prices. There are rival ETFs backed by physical holdings of silver, platinum and palladium.

“The spot price for gold bullion is determined by market forces in the 24-hour global over-the-counter (OTC) market for gold. The OTC market accounts for most global gold trading, and prices quoted reflect the information available to the market at any given time,” according to State Street, GLD's issuer.

The thing that confuses some novice investors is that they do not realize owning an ETF like GLD is just paper ownership. No gold is delivered to your door when you sell shares in these commodities ETF. Plus, precious metals ETFs like this are taxed as collectibles when investors, usually meaning a higher rate of tax than traditional capital gains.

Futures

Holding futures contracts is one of the most frequently used methodologies for commodities ETPs. In fact, it is the methodology used by some of the most heavily traded commodities products on the market, including the United States Oil Fund (USO) and the United States Natural Gas Fund (UNG).

However, futures-based commodities ETFs are often flawed products best used by short-term traders, not buy-and-hold investors. Many of futures-based ETFs only hold the nearest month contracts or the nearest two months of futures contracts.

That means these funds are constantly rolling futures contracts, driving up investors' costs in the process. This methodology also exposes users of these funds to contango, the scenario by which investors pay more today for a commodity futures contract than the spot price of that commodity is expected to be in the future.

Index Funds

The index fund is the typical structure for an equity or fixed income ETF and there are plenty of commodities ETFs that are index funds. In fact, several of the largest commodities funds are basic index funds.

That includes the $1.95 billion PowerShares DB Commodity Index Tracking Fund (DBC). DBC, which is over 11 years old, tracks the DBIQ Optimum Yield Diversified Commodity Index Excess Return.

DBC “is designed for investors who want a cost-effective and convenient way to invest in commodity futures. The Index is a rules-based index composed of futures contracts on 14 of the most heavily traded and important physical commodities in the world,” according to PowerShares.

DBC is a good example of what investors should expect with commodity index funds, that being exposure to multiple commodities. Most ETFs of this nature are heavily allocated to energy commodities and precious metals with industrial metals and agriculture commodities taking a back seat.

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