Find out more about investing in commodity ETFs, including what they are, things to research, and some of the common types of these investment products.
Bullish on gold? Bearish on oil? Think lean hog prices are going to rally? Okay, 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 exchange-traded fund (ETF) in 1993 before commodity ETFs became available. According to ETF.com (an ETF data and news subisidiary of Cboe Global Markets), as of June 2020, there are 137 different commodity ETFs, with total invested assets of $121 billion.
But as with any investment, ETFs tracking gold, oil, agriculture, and other commodities aren’t without risk. It’s important to research and understand them before you make a decision. This overview isn’t exhaustive for your due diligence, but it’s a good starting point.
Commodity ETFs are a type of exchange-traded fund. An ETF is a group of securities that’s designed to track an underlying asset or index and can be traded intraday like an individual stock. ETFs may invest in physical commodities such as grains, livestock, energy, or precious metals. Some types of ETFs actually hold the commodities in physical storage. For others, although they’re referred to by the general term “ETF,” they’re technically exchange-traded notes (“ETNs”—more on that below). Many funds use futures contracts—standardized contracts for future delivery that are traded on futures exchanges such as CME, CBOT, and NYMEX (three exchanges owned by CME Group).
There are also some ETFs that do both—they invest in physical commodities and use futures contracts.
ETFs can 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. 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 so in the future.
In addition to ETFs, there are also commodity ETNs, which often get lumped together in discussion (sometimes under the umbrella of exchange-traded products, or ETPs). Although both ETP types are traded on exchanges, ETNs are debt securities, whereas ETFs are investment funds. The performance of an ETN tracks an underlying index, like some ETFs; however, because an ETN is essentially a tradable loan issued by a financial company, investors are exposed to credit risk. That’s 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 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. Before you invest, you should always read the fund prospectus to help you know what you’re getting into.
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.
After reading 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 aren’t sure 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 following. Expenses and other factors can cause a fund’s performance to diverge from the asset or index it’s supposed to be tracking.
Finally, researching what drives commodity prices is essential before trading or investing. Commodity prices tend to be cyclical, driven largely 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.
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 predetermined date in the future. In general, futures prices differ from spot prices, that 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 (spot) prices. Sometimes that premium exists because investors are willing to pay more for the commodity in the future rather than buy the commodity today and pay costs associated with storage. As the contract gets closer to expiration, this premium begins to “decay,” until the price of the expiring futures contract matches the cash price.
So what does that have to do with you investing in commodity ETFs/ETNs? You’re essentially investing in futures contracts if they’re in the ETF. As a fund’s near-term futures contracts approach expiration, certain contracts may need to be rolled over into longer-term futures delivery dates so the fund isn’t forced to take physical delivery of a commodity.
When the market is in contango, fund managers end up paying more for the longer-term contracts than what they receive from selling the shorter-term contracts, which results in the net price of your investment going down. This is called “negative roll yield,” or simply “roll decay,” and it can really add up over time and negatively affect returns.
Although there’s a wide variety among these products, most of them tend to fall within these broad categories:
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, the ultimate question is whether or not they fit into your investment strategy.
The key is to think strategically instead of tactically. Commodities can work well in a diversified portfolio because of the alternative investing exposure they provide versus stocks and bonds. Trying to time fluctuations in commodities in the short term can potentially whipsaw your portfolio. But a core holding might be a good hedge during times when stocks or bonds are unable to provide that stability.
With commodity ETFs—or any alternative investment, for that matter—a little might go a long way. Given how volatile commodities tend to be, if you’re interested in adding these products, an appropriate allocation is important. Companies involved in the commodities supply chain (think oil companies, gold miners, and those involved in food production and distribution) might offer the same type of diversified exposure, but with potentially less volatility. Again, it’s all about your personal objectives, risk tolerance, and investment horizon.
*Before investing in an ETF, carefully consider the fund’s investment objectives, risks, charges and expenses. For a prospectus containing this and other important information, contact the fund or contact a TDAmeritrade Client Services representative at 800-669-3900. Please read the prospectus carefully before investing.
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