Investing in commodity ETFs provide a way for investors to gain exposure to commodities even without actually owning a live cattle, a barrel of crude oil, or a bar of gold. 

Commodity ETFs Methodologies

Generally speaking, there are two ways by which commodity ETFs invest in commodities.

The first one is direct investing in commodities. As the name suggests, the commodity ETF invests directly in physical commodities, such as gold and cattle. The other methodology is about buying derivatives, such as futures contracts and swaps.

Because of the problems linked with holding, trading, and delivering huge amounts of physical commodities, many commodity ETFs choose the second method. That’s because it removes the logistical challenges along with the expenses. Aside from that, it also reduces the tracking errors against the benchmarks.

The ease and convenience of contracts over direct investing makes it a lot more easier for managers to keep up with the changing marketplace.

The Downsides of Trading Commodity Derivatives

Meanwhile, there are also some downsides to trading commodity derivatives. For example, a gold bar can be safely tucked in a vault and it will never lose its intrinsic value. But contracts do expire and become worthless.

The expenses for replacing them can be greater than the initial acquisition cost, leading to an event called ‘contango.’ This expense will inevitably diminish the investment returns.

The reverse is also true, and that event is in turn called ‘backwardation.’ This means that there may be no charge for buying the next contract. There are even instances where the investor is paid to make the purchase.

Commodity ETFs Features

ETFs provide different levels of portfolio concentration. Some of them invest only in a single commodity while others hold a variety of commodities. There are four major areas of commodity investment, namely: energy, agriculture, precious metals, and industrial metals.  Within each category are a bunch of additional offerings.

For energy, you may get exposure to crude oil, heating oil, gasoline, and natural gas, among others. Different ETFs offer strategies either concentrated on a particular type of energy or a combination of sources.

Agriculture gives you exposure to cattle, coffee, cotton, orange juice, grain, and many others.

Precious metals can expose you to gold, silver, palladium, and platinum, among others. Industrial commodities, on the other hand, are those that provide exposure to aluminum, nickel, copper, tin, and lead.

Advantages and Downsides

A more concentrated portfolio or one that specializes in a particular commodity may provide greater exposure and greater returns. However, it may also expose the investor’s portfolio to greater risks.

For example, a portfolio that is concentrated on gold may suffer tremendous damage if gold prices collapse. But if you have a broad-based portfolio that is exposed to other types of precious metals and commodities, a downturn in gold prices might not be as detrimental.

Meanwhile, different commodity ETFs provide different opportunities to use various strategies and exposures, as well as various risks.

The spot price, or the price of the physical commodity, may be reflected in the price of a commodity ETF because of contango, ETF strategy, and plethora of other factors.

And of course, investors should take the time to learn about the nitty-gritty of commodity ETFs and determine the exact role that they will play in their portfolios before investing in such funds.