Commodity ETFs are exchange-traded funds (ETFs) that provide exposure to the price changes of raw materials, such as agricultural goods, natural resources, or metals.
What are commodity ETFs?
Commodity ETFs invest in commodities and are frequently structured in one of two ways:
Commodity ETFs can buy and store the physical commodity itself. The primary examples of this type of ETF are the two largest gold funds, SPDR® Gold Shares (GLD) and iShares® Gold Trust (IAU). These are technically trusts, and they use their assets to buy gold bullion to store in bank vaults.
The second structure for commodity ETFs is futures contracts. These trade on exchanges, similar to stocks and bonds, and don't require storage like a physical commodity does. When a futures contract approaches the delivery date, the holder will typically "roll" that contract in exchange for another contract on the same commodity to be delivered further in the future.
Commodity ETFs provide a low-cost way to access asset classes that might otherwise be difficult to invest in and can help you diversify your portfolio.
What are some common types of commodity ETFs?
Within the commodity category, you can obtain broad or narrow exposure to single commodities or baskets of commodities. Some products are even actively managed baskets of various commodities based on different strategic benchmarks and various other factors. Here are some examples of common types of commodity ETFs:
Invest in physical commodities, typically gold or silver bars, which are stored in secure vaults.
Invest in commodity futures. A commodity futures contract is an agreement to deliver or receive a certain commodity at a certain date in the future for a price agreed upon today. Investors in these types of ETFs will receive K-1s at tax time.
Some actively managed ETFs are able to invest in commodity futures but avoid distributing K-1s to investors by holding futures contracts within Cayman Island subsidiaries. These Cayman Island trusts invest in commodity futures contracts and other derivatives on behalf of the fund.
Exchange-Traded Notes (ETNs)
ETNs consist of a promise by an issuer to repay the face value plus the return on a referenced commodity index, minus fees. Unlike ETFs, ETNs are debt notes not secured by any underlying assets or securities; as a result, the creditworthiness of the issuer should be monitored. Note that ETN issuers may accelerate the redemption of certain ETNs at their discretion.
Some ETFs primarily hold the stocks of commodity-producing companies, such as gold-mining or oil-drilling firms. While the performance of such companies does depend somewhat on the price of the commodity, these funds may perform more in line with other stock ETFs than with commodity prices.
What are the pros and cons of commodity ETFs?
To help you determine if commodity ETFs are right for your portfolio, it’s important to examine some of the benefits and risks.
Many investors turn to commodities for diversification and/or may seek a level of protection against inflation.
Investments in commodities can be volatile. Allocating more than 5%–10% of a portfolio to commodities may reduce the diversification benefits.
Contago is when the future price is above the spot price. Contango occurs when investors are willing to pay a premium today to be sure of the price they'll get in the future. If the market for a particular commodity suffers from strong, persistent contango, an ETF that buys futures contracts on that commodity will perform worse than the spot price of the commodity over time as lower-valued, near-term contracts are consistently replaced with higher-valued, longer-dated contracts.
Backwardation is the opposite of contango. It means that the futures price is lower than the spot price. In backwardation, contracts tend to increase in value as they approach maturity.
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