By definition, commodities are basic goods. And basic goods can potentially be good investments.
Why Invest in Commodities?
Commodities are an asset class that are typically negatively correlated with other asset classes, such as stocks and bonds. This means that when stocks and bonds decrease in value, commodities will increase in value, and vice versa. As a result, they offer investors a good way to diversify their investment portfolio. Commodities also offer a hedge against inflation.
The problem for most investors is that historically, it was difficult to get direct exposure to commodities in a cost-effective and risk tolerable manner.
The Solution: Commodity ETFs
Commodity ETFs enable investors to gain exposure to individual commodities or baskets of commodities in a simple, relatively low risk and cost-effective manner. There are numerous ETFs that track different commodities, including base metals, precious metals, energy and agricultural goods, with which investors can design their ideal commodity exposure.
Types of Commodity ETFs
There are four different types of commodity ETFs:
There are advantages and disadvantages to each of the different types, so the choice will depend on an individual investor’s investment goals, risk tolerance, and cost tolerance.
Equity-based commodity ETFs hold stock in the companies that produce, transport and store commodities. An equity-based commodity ETF can give investors exposure to multiple companies or specific sectors, but in a simpler, more inexpensive manner than buying the underlying companies themselves.
This can also be a cheaper and safer way to gain exposure to commodities, as the risks involved with both physical and futures commodity ETFs don’t apply. And the expense ratios for the funds tend to be lower. The drawback is that investing in equity places an additional layer – the company structure itself – between the investor and the commodity they want to gain exposure to.
Exchange-Traded Notes (ETNs)
The second type of commodity ETF is an Exchange Traded Note (ETN), which is a debt instrument issued by a bank. It is senior, unsecured debt that has a maturity date and is backed by the issuer. ETNs seeks to match the returns of an underlying asset and they do so by employing different strategies, including buying stocks, bonds, and options. The advantages of ETNs are that there is no tracking error between the ETN and the asset it is tracking and they receive better tax treatment because an investor only pays regular capital gains when it is sold. The main risk involved with ETNs is the credit quality of the issuing institution.
The third type, physically-backed ETFs, actually hold physical commodities in their possession and are limited to precious metals at the moment. The advantage of a physical ETF is that it actually owns and has possession of the commodity. This removes both tracking and counterparty risk. Tracking risk occurs when the ETF you own doesn’t provide the same returns as the asset it is supposed to track. Counterparty risk is the risk that the seller does not actually deliver the commodity as promised.
The disadvantage of physically-backed ETFs is that there are costs involved with delivering, holding, storing and insuring physical commodities – costs which can add up. The avoidance of these costs is what often pushes investors to buy commodity futures instead. And note that physical precious metal ETFs are taxed as collectibles, which means capital gains are taxed at your marginal tax rate, depending on your tax bracket. Short term gains are taxed at ordinary income rates.
The most popular type of commodity ETFs are futures-based. These ETFs build a portfolio of futures, forwards, and swap contracts on the underlying commodities. The advantage of a futures-based ETF is that the ETF is free of the costs of holding and storing the underlying commodity. But there are other risks that relate to the futures contracts themselves.
Most futures-based commodity ETFs pursue a “front-month” roll strategy where they hold “front month” futures, which are the futures that are closest to expiring. The ETF needs to replace those futures before they expire with the second-month (the subsequent month) futures. The advantage of this strategy is that it closely tracks the current, or spot, price for the commodity. The disadvantage is the ETF is exposed to “rolling risk” as the expiring front month contracts are “rolled” into the second month contracts.
Commodity markets are usually in one of two different states: contango or backwardation. When futures are in contango, prices for a particular future are higher in the future than they are now. When futures are in backwardation, prices for a commodity are higher now than they are in the future.
When a futures market is in contango, the rolling risk is “negative”, which means that a commodity ETF will be selling lower priced futures that are expiring and buying higher priced futures, which is known as “negative roll yield.” The cost of adding higher priced futures reduces returns and acts as a drag on the ETF, preventing it from accurately tracking the spot price of the commodity.
There are commodity ETFs that pursue laddered strategies and optimized strategies that are designed to avoid the risks posed by a market that is in contango. A laddered strategy uses futures with multiple expiry dates, which means not all the futures contracts are replaced at once. An optimized strategy attempts to choose futures contracts that have the mildest contango and the steepest backwardation in an attempt to minimize costs and maximize yields. Both of these approaches may minimize costs but do so at the expense of actually tracking and potentially benefiting from short term moves in the price of the underlying commodity. As such, they may be more suitable for longer-term, more risk averse investors.
When a futures market is in backwardation, the rolling risk is “positive,” which means a commodity ETF will be selling higher priced futures that are expiring and buying lower priced futures, creating what is known as “positive roll yield.”
Regardless of which condition the futures market is in, futures-based commodity ETFs incur higher expenses because of the need to constantly roll over futures contracts. Expense ratios for unleveraged futures-based commodity ETFs typically range from 0.50%-1.0% but vary from fund to fund and commodity to commodity. Be aware that leveraged commodity fund expense ratios typically start at 1.0% and can often range higher.
An additional risk that futures-based commodity ETFs face is that instead of simply tracking commodity prices, ETFs may influence futures prices themselves due to their need to buy or sell large numbers of futures contracts at predictable times, known as a “roll schedule.” This also places the ETFs at the mercy of traders who may bid prices up or down in anticipation of the ETF trade orders. Finally, ETFs may be limited in the size of the commodity positions that they can take on due to commodity trading regulations.
Finally, most futures-based commodity ETFs are incorporated as Limited Partnerships. For tax purposes, 60% of the gains are taxed as long-term capital gains and the remaining 40% are taxed at the investor’s ordinary tax rate. Another thing to consider is that the LP’s gains are marked to market at the end of the year, which may create a taxable event for an investor, even if they haven’t sold any of their shares in the ETF.
Choose Commodity ETFs Wisely
Commodity ETFs can be a great way for investors to gain some commodity exposure in their portfolio. There are many different types of commodity ETFs that focus on different commodities, use different strategies, and have varying expense ratios. The selection of what ETF is right for you will depend on your investment goals and risk tolerance. Take heed, do your research, and know what you’re buying.