Guide to commodity ETFs

Commodity ETFs provide investors with unique and targeted exposure to commodities, an asset class that has the potential to provide diversification benefits to portfolios. However, not all commodity ETFs are created equal. Commodity ETFs can be physically backed, futures-based, or invest in related equities. Some commodity exchange-traded products are even structured as debt instruments that track a related commodity index. Each of these products has a unique set of benefits and risks, so it is important to understand the differences between each before making an investment. This guide to commodity ETFs dives into the differences between each type of commodity ETF and some factors investors should consider before using ETFs to invest in this asset class.

What are commodity ETFs?

Commodity ETFs offer exposure to price changes in physical commodities such as agricultural commodities, natural resources, and precious and industrial metals. Commodity ETFs can offer broad exposure to a basket of various commodities or they can be more targeted, tracking the price of a single commodity like gold. 

What is the difference between commodity ETFs and commodity ETNs?

Commodity ETFs provide exposure to the price change of underlying commodities through holding stocks, derivatives, or other ETFs. Investing in a commodity ETF means that you own a slice of the underlying basket of assets.

In contrast, commodity ETNs are unsecured debt instruments. Buyers of a commodity ETN do not hold an underlying basket of assets. Instead, ETNs are issued by an institution and usually rely on derivatives to provide the return of the index tracked by the ETN. This means that buyers of ETNs are not subject to tracking error but are exposed to counterparty risk. If the issuer of the ETN does go bankrupt, the investor risks losing their investment. 

What are physically backed funds?

Physically backed ETFs have possession of the physical commodity itself and at this time, are limited to precious metals. Owning a physically backed ETF means that there is no counterparty risk or tracking error. However, physically backed funds do incur costs to deliver, hold, and store the commodity. 

One other thing to know about physically backed ETFs is their tax treatment, which differs from other types of commodity ETFs. When you buy a physically backed ETF, your investment is treated as if it is an investment in the metal itself. This means that it is taxed as a collectible, and can be subject to a 28% top federal tax rate on long-term capital gains – higher than the top long-term rate of 20% for other types of investments.

What are future based ETFs?

Many other commodity ETFs aside from precious metals are structured using futures contracts. These ETFs typically buy the “front month” contract, as this provides the highest correlation to the spot price of the underlying asset. When the contract nears expiration, the ETF “rolls” into the next month’s contract. Since there is likely to be a price difference between these two contracts, the cost (or gain, depending on the shape of the futures curve) is referred to as “roll yield,” which can create a tracking error relative to the spot price. 

However, since these ETFs do not require ownership of the physical commodity itself, they are not subject to the costs of delivering, holding, or storing the commodity like physically-backed ETFs are.

What are equity-based commodity ETFs?

Rather than providing exposure to the price of the commodity itself, equity-based commodity ETFs own equities of companies that produce, transport, and store commodities. An example would be a fund that offers exposure to gold miners, rather than the metal itself. 

Since this type of ETF owns stocks of companies associated with a specific commodity, they are not subject to the same risks as futures-based or physically backed commodity ETFs. However, while these ETFs are likely to be somewhat correlated with the price of the underlying commodity, they will not track the spot price and can often have periods of higher volatility.

What are the benefits and risks of commodity ETFs?

As outlined above, each type of commodity ETF has its own set of risks. But why do investors want commodity exposure in the first place? There are two main benefits to owning commodity ETFs: diversification and strong performance during inflationary environments.

Commodities as an asset class tend to have low or negative correlations to more traditional asset classes such as stocks or bonds. This means that they provide diversification to a portfolio. Historically, prices of things such as oil and gold have increased during periods of higher inflation.

Commodity ETFs and ETNs make it simple to get exposure to this asset class. Investors don’t need to buy and store the commodity itself or manage futures contracts and expiration dates. Instead, investors can purchase a fund that offers exposure to one or more commodities just as easily as they would get exposure to the S&P 500.