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DEFINITION of 'Commodity ETF'

Commodity ETFs are exchange-traded funds (ETFs) that invest in physical commodities, such as agricultural goods, natural resources and precious metals. A commodity ETF is usually focused on either a single commodity, holding it in physical storage, or it is focused on investments in futures contracts. Other commodity ETFs look to track the performance of a commodity index that includes dozens of individual commodities through a combination of physical storage and derivatives positions.

BREAKING DOWN 'Commodity ETF'

ETFs usually consist of public equities that relate to a specific economy, market index, sector or industry. Normal ETFs are made up of a collection of securities that are linked by a similar investment profile. Instead of underlying securities like public stocks, commodity ETFs are comprised of futures or asset-backed contracts that track the performance of a particular commodity or group of commodities.

When an investor purchases a commodity ETF, he normally does not own the physical asset, but instead owns a set of contracts backed by the commodity itself. Since many commodity ETFs use leverage through the purchase of derivative contracts, they may have large portions of uninvested cash, which is used to purchase Treasury securities or other nearly risk-free assets.

Commodity funds often create their own benchmark indexes that may include only agricultural products, natural resources or metals. As such, there is often tracking error around broader commodity indexes like the Dow Jones AIG Commodity Index. Even so, any commodity ETF should be passively invested once the underlying index methodology is in place. Commodity ETFs have soared in popularity because they give investors exposure to commodities without requiring the investors to learn how to purchase futures or other derivative products.

Examples of Commodity ETFs in the Market

Commodity ETFs track a wide range of underlying commodities, some of which include precious metals, oil and natural gas. Further, other commodity ETFs instead track a diversified basket of commodities. Investors should always do their own research, but some of the best commodity ETFs are as follows.

Precious metals like gold and silver are popular ETFs because the underlying commodity can't go bad or spoil. 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 0.4%, and the iShares Silver Trust has an expense ratio of 0.5%.

Another popular type of commodity ETF is oil and natural gas. However, since oil and gas can't be stockpiled like precious metals, these ETFs invest in futures contracts instead of the commodity itself. The SPDR S&P Oil & Gas Exploration and Production ETF has a diversified portfolio of 60 oil- and gas-producing companies and has an annual expense ratio of 0.35%.

Some investors like to increase diversification through diversified commodities ETFs. These ETFs, such as the iShares MSCI Global Agriculture Producers ETF, tracks the United States Commodity Index.

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