Commodity ETF

What Is a Commodity ETF?

A commodity ETF is an exchange-traded fund (ETF) invested in physical commodities, such as agricultural goods, natural resources, and precious metals. A commodity ETF is usually focused on either a single commodity held in physical storage or investments in commodities futures contracts.

Other commodity ETFs track the performance of a broad commodity index that includes many individual commodities representing a combination of physical storage and derivatives positions.

Understanding Commodity ETFs

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, they normally do not own the physical asset but instead own 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 such as the Dow Jones AIG Commodity Index. Even so, any commodity ETF should be passively invested in once the underlying index methodology is in place.

Commodity ETFs have soared in popularity because they give investors exposure to commodities without requiring investors to learn how to purchase futures or other derivative products.

It pays to research commodity ETFs, researching the overall concept in great detail, and watching the commodity ETF for a while to see how it progresses as the market changes. 

Commodity ETF vs. Commodity Exchange-Traded Note (ETN)

Often confused with ETFs, an exchange-traded note (ETN) 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 seek to match the returns of an underlying asset and they do so by employing different strategies, including buying stocks, bonds, and options. Advantages of ETNs include limited tracking error between the ETN and the asset it is tracking and better tax treatment — an investor only pays regular capital gains when the ETN is sold.

The main risk involved with ETNs is the credit quality of the issuing institution.

Examples of a Commodity ETF

Commodity ETFs track a wide range of underlying commodities. Some focus on specific commodities, including precious metals, oil, and natural gas, while others have a broader reach and track a diversified basket of commodities.

Investors should always do their own research, but some of the best commodity ETFs invest in precious metals such as gold and silver. These 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.

Another popular type of commodity is oil and natural gas. Oil and gas can't be stockpiled like precious metals, so these ETFs invest in futures contracts instead of the commodity itself. An example of an ETF in this sector is the SPDR S&P Oil & Gas Exploration and Production ETF, which has a diversified portfolio of 56 oil- and gas-producing companies.

Alternatively, some investors choose to increase diversification through diversified commodities ETFs. These funds spread their bets by investing in a range of different commodities.

Unique Risks of Commodity ETF Investments

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 to avoid the risks posed by a market that is in contango. A laddered strategy uses futures with multiple expiry dates, meaning 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%-1.00% but vary from fund to fund and commodity to commodity. Be aware that leveraged commodity fund expense ratios typically start at 1.00% 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.