Bullish on gold? Bearish on oil? Think lean hog prices are going to rally in 2017? The average investor usually isn’t too focused on the outlook for lean hogs, but that isn’t necessarily the case for gold, oil, and other commodities. It didn’t take too long after the launch of the first ETF in 1993 before commodity ETFs became available. In recent months, investors have been pouring billions into these funds, according to the equity research firm ETFGI.
Like any investment, they’re not without risk and it’s important to research and understand them before you make a decision; so we’ll start with the basics, then take a look at some things to consider before investing, and finally we will explore different types of commodity ETFs. This is by no means an exhaustive inquiry, but more of an overview that can help you get started.
What Are Commodity ETFs?
Commodity ETFs are a type of exchange-traded fund (ETF), which is a group of securities designed to track an underlying asset or index that can be traded intraday like individual stocks. They invest in different physical commodities, such as in agriculture or precious metals. Some types of ETFs actually hold the commodities in physical storage and others use futures contracts—a contract traded on an exchange to buy or sell assets at a fixed price that will be delivered and paid for later. There are also some ETFs that both invest in physical commodities, as well as use futures contracts.
One of the main attractions of ETFs is that they make it easier to gain exposure to commodity markets without having to trade futures or deal with purchasing (and storing) physical raw commodities such as oil or precious metals. Another reason is that over the long-run, commodities tend to provide uncorrelated returns compared to stocks and bonds, which is why some investors choose them for additional diversification. In the past, commodities have performed well during periods of high inflation, leading some investors to invest in them as a potential hedge against inflation. However, just because they performed well under certain conditions in the past doesn’t mean they’ll do the same in the future.
In addition to ETFs, there are also commodity exchange-traded notes (ETNs), which often get lumped together in discussion. While both products are traded on exchanges, ETNs are debt securities whereas ETFs are an investment fund. The performance of an ETN tracks an underlying index like some ETFs, however, because they are essentially a tradable loan issued by a financial company investors are exposed to credit risk—the possibility the issuer could default, resulting in a loss of principal. And that’s not the only risk you might want to consider with these products.
First, there’s always the chance your investment could lose value. Commodities can also be very volatile and are affected by world events, government regulations, changes in import and export policies, and economic conditions. On top of that, production for certain commodities can be concentrated in foreign and emerging markets, which can be disrupted by political, economic, and currency instability. With each individual issue, there will be different risks you should consider.
Researching Commodity ETFs/ETNs
First off, the prospectus is a great place to start to learn more about a specific ETF/ETN you’re considering. It’s a document that must be filed with the Securities and Exchange Commission and provides additional information about: risks, past performance, portfolio holdings, investment strategies, management, distribution policies, fees and expenses, as well as other supplemental information.
Once you get done with the prospectus, examine how the product you’re considering is taxed, which can vary depending on your individual situation and how the investment is structured. Some commodity ETFs will issue a Schedule K-1 to investors, which is a tax document used to report a partnership’s incomes, losses and dividends—this can add more work and complexity when it comes time to file your taxes. These products are complicated and if you don’t feel like you understand the tax implications you might want to consult with a tax professional before investing.
On top of the prospectus and taxes, you may want to review how well the fund’s performance tracks the performance of the underlying asset or assets it’s supposed to be tracking. When there is a discrepancy it is known as tracking error, which is the difference between a portfolio’s returns and the benchmark or index it’s tracking. Expenses and other factors can cause a fund’s performance to diverge from the asset or index it’s supposed to be tracking. ETNs typically have a lower tracking error due to the way they are structured.
ETF trading commissions can also impact overall portfolio performance, especially if over time you’re regularly investing smaller amounts of money. More online brokers are starting to offer commission-free ETFs, which can help investors reduce those costs.
And finally, researching what drives commodity prices is essential before trading and investing. Commodity prices tend to be cyclical and a basic explanation is they are driven by supply and demand. Global macroeconomic conditions, weather, and shifts in technology are just some of the things that can impact supply and demand—ultimately leading to shifts in price.
Contango and Commodity ETFs/ETNs
If you’ve researched these products, you’ve probably come across the word contango. The concept behind this funny sounding word can have a substantial impact on the performance of ETFs/ETNs that use futures.
Remember that a futures contract is an agreement to buy or sell an asset (oil, gold, etc.) at a pre-determined date in the future. In general, futures prices differ from spot prices, which is the real-time cash price. If a futures contract price is higher than the spot price, this is called contango.
For example, crude oil is said to be “in contango” when longer-dated contracts trade at increasingly higher premiums over cash prices. The premium sometimes exists due to investors’ willingness to pay more for the commodity in the future than buying the commodity today and paying costs associated with storage. As the contract gets closer to expiration, this premium begins to “decay,” until the price of the expiring future matches the cash price.
So what does that have to do with you thinking about investing in commodity ETFs/ETNs? You’re essentially investing in futures contracts if they’re in the investment you are buying and selling. As a fund’s near-term futures contracts approaches expiration, what can end up happening is that certain contracts need to be rolled over into longer-term futures expirations so the fund avoids being forced to take physical delivery of a commodity.
When the market is in contango, fund managers end up paying more for the longer-term contract than what they receive from selling the shorter-term contract, which results in the net price of your investment going down. This is called rolled decay, and this can really add up over time and negatively impact returns.
Common Types of Commodity ETFs/ETNs
While there’s a wide variety among these products, most of them tend to fall within these broad categories:
1. Agriculture: focuses on agricultural goods, such as cocoa, sugar, wheat, corn, soybeans, coffee, cotton, and hogs. In the short-term, agricultural commodity prices can be very volatile depending on weather and, depending on where production for a specific commodity is concentrated, geopolitical concerns can also come into play. Unlike other commodities, spoilage can be an issue with agricultural goods, adding another risk to consider.
2. Energy: includes natural gas, gasoline, and oil. Investors that are bullish on long-term energy consumption and economic growth might consider energy commodities. Energy prices can be impacted by seasonal conditions; for example, natural gas demand usually goes up if it’s a particularly cold winter or down if it’s a warm winter.
3. Precious Metals: such as gold, silver, platinum, and palladium. Some of these metals are used in jewelry and industrial applications, but a large portion of available supply is held by governments and individuals throughout the world. Some investors use them as a potential hedge against inflation or when markets are volatile.
4. Industrial Metals: encompasses non-precious metals used in industrial applications including copper, nickel, tin, and aluminum. Investors might choose different industrial metal ETFs if they are bullish on overall economic growth or specific industries that require these metals in their operations.
This is just a high-level look at the different commodity categories. Within each of these, you’ll find a variety of products. If you’re considering any of these types of investments, it’s ultimately about whether or not they fit into your investment strategy.
For more information on ETFs, be sure to check out TD Ameritrade ETF Market Center.
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