What to Know Before Trying Commodity ETF Investing

Commodity ETF investing offers a new way for investors to participate in one of the oldest markets. Through commodity ETFs, it is possible to for even smaller investors diversify into commodities and buy things that were never traded on the stock market before. However, the risks remain relatively high and there are various factors that need to be taken into consideration for smart investing.

Reasons to use ETFs

Unlike mutual funds, ETFs are designed only to follow the markets they are invested in and do not try to beat them (see, What Is an ETF). This gives them less overhead and much lower costs. ETF operating costs and fees are often kept under 1%. At the same time, being pools of money, they make it possible for investors to diversify into more markets than would otherwise be practical. With the ability of ETFs to be bought and sold like stocks, there has never been an easier way to invest in commodities.

In addition, investors can potentially lose more than the value of their investments in futures contracts. In commodity ETF investing, this loss is limited to the performance of the ETF.

Reasons to consider commodity investing

There are a number of reasons for investors to consider commodities as a long-term investment. The world’s population is still growing, and literally hundreds of millions of people are joining the middle class in nations like China and India. In addition, nobody knows for sure what factors like climate change will have on the food supply. While nobody can be certain, it is reasonable to assume that all these factors are likely to increase the demands on commodities and drive up prices over time.

Traditionally, commodities have been considered the best hedge against inflation. With commodity ETFs, they can also be a way to diversify one’s portfolio and sometimes hedge it against drops in the stock market. This is because stocks and commodities often move in different directions. On the other hand, there are also many instances where they will move together, and commodity investing remains more speculative than investing in stocks.

Risks

Commodity prices are more volatile than stocks. Without earnings or other fundamentals, which are at least partially under human control to factor in, commodity prices are driven entirely by supply and demand factors. These factors are sometimes more perceived than real, and price rises and falls can take on a life of their own that has almost nothing to do with the actual supply situation. With so much hedging and speculation, there are all too many two-way (long/short) transitions to drive prices.

How commodity ETF investments work

Commodity ETFs do not usually directly buy the actual commodities themselves. What they do purchase are futures contracts. Since futures contracts can leave one owing more than the amount invested, most ETFs only have a portion of their money invested in these contracts and put the rest is put into Treasury bills. When contracts are about to expire, commodity ETFs will roll the investment into the next contract.

Due to the nature of futures contracts, the value of the fund will not necessarily follow the price of the commodities. For example, if the markets are overly bullish on the future price of a commodity and price it at a level that is higher than the actual price when the contract expires, the fund will experience a loss even if the commodity price has experienced a more moderate increase. While this dynamic works both ways, it does add volatility and makes it impossible for most ETFs to truly track the commodity prices.

Types of commodity ETFs

Physically backed ETFs: This is one form of ETF that will closely follow the actual value of the commodity. Since these investments hold the actual commodities, they track the prices of them almost exactly. The drawback of this type of investing is that it is inordinately expensive to physically hold most commodities. Unless the commodity is something that is not living, perishable or is in to store, the costs of taking possession of the actual commodity are too high to be practical. The commodities are the best for physically backed ETFs include gold, silver and platinum, which can be locked away in faults or are small enough in size to be easily stored.

Futures based ETFs: Since the majority of commodities cannot be easily held as assets, futures based ETFs are the most common. By selling these futures contracts before they expire and putting the proceeds into contracts that have a lot more time left on them, the ETFs can avoid having to take possession of the commodities.

Pointers on commodity ETF investing

It is usually best to avoid ETFs that are specialized or concentrated on exotic commodities. Stay with more broad based funds.

Funds that concentrate on longer contracts will be less sensitive to changes in spot commodity prices. While this can have both positive and negative results on returns, it does keep them more stable.

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