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Getting Started With Commodity ETFs

Getting Started With Commodity ETFs

Key Points
  • Commodity ETFs can help provide relatively low-cost access to an asset class that's otherwise difficult to invest in.

  • While commodities can be useful as a hedge against inflation, they generally shouldn't make up a very large portion of your assets—typically no more than 5% to 10% for most investors. 

One feature of exchange-traded funds (ETFs) that many investors find attractive is relatively low-cost access to asset classes that can be otherwise difficult to invest in. The poster child is commodities—physical goods such as precious metals, oil and agricultural products. While it can be tough for a typical investor to buy and store these goods, an ETF can help grant access with relative ease.

Before diving in, however, there are certain issues to consider.

First, what role should commodities play in your portfolio? Many investors turn to commodities for diversification and seek a level of protection against inflation. While commodities can be useful as a hedge against inflation, they generally shouldn't make up a very large portion of your assets—no more than 5% to 10% for most investors. More than that may reduce the diversification benefits, with too much of your portfolio's risk then coming from commodities alone.

Secondly, but just as important, you need to understand what makes commodity ETFs different from other ETFs, and how they can differ from each other.

Structures of commodity ETFs

Most investors are familiar with stock ETFs, which are portfolios made up of actual shares of common stock. A commodity ETF, by contrast, is typically structured in one of three ways.

The first and simplest structure buys and stores the physical commodity itself. The primary examples of this type of ETF are the two largest gold funds, SPDR Gold Shares (GLD) and iShares Comex Gold Trust (IAU). These are technically trusts, and they use their assets to buy gold bullion to store in bank vaults.

The second common structure is a fund that holds futures contracts. A futures contract on a commodity is an agreement to deliver a certain commodity at a certain date in the future for a price paid today, such as paying $100 today for a barrel of oil to be delivered in three months.

Futures contracts 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.

Examples of futures-based commodity ETFs are US Oil Fund (USO) and PowerShares DB Commodity Index (DBC).

Understanding contango

Investors who buy ETFs that use commodity futures contracts are sometimes surprised to see that the ETF does not move in lockstep with the price of the commodity as seen in the news, oil being a good example. This is because of a phenomenon called contango.

Contango simply means that investors are willing to pay a premium today to be sure of the price they'll get in the future, rather than waiting a month or quarter and then buying the commodity in the real-time "spot" market. For example, say oil is trading at $100 per barrel today (the spot price). Investors may be so concerned about higher prices in the future that they're willing to pay $102 per barrel now for a contract that promises to deliver oil one month from today. When the future price is above the spot price, that's contango. (The opposite situation, where the future price is below the spot price, is called backwardation.)

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 itself. If you invest in a fund that always buys one-month oil futures contracts, for instance, and that fund has to pay $2 more than the spot price for them, the fund will essentially lose $2 per barrel each month when they roll their futures contracts. This is because they will have to sell their expiring contracts near the spot price and buy new contracts at a price higher than the spot.

In addition, if an ETF that buys futures contracts is very large (assets in the tens of billions of dollars), it might be possible for other investors to trade ahead of the fund when it's time to roll its contracts each month. Such investors might know that the fund is not equipped to take delivery of the commodity, and is scheduled to sell billions of dollars worth of expiring contracts and buy billions of dollars worth of contracts for a month in the future. Knowing that a large fund is about to buy a particular futures contract (pushing up its price), these investors could buy the contract ahead of time at the lower price and sell to the ETF at the higher price—in which case investors who own the ETF will see slightly worse performance than they would otherwise.

What can you do as an ETF investor?

  • Be aware of the difference between a commodity ETF that relies on futures contracts and one that buys and sells at spot prices (look at the fund's prospectus to see what kind it is). The futures fund will do worse when there's contango but better when there's backwardation.
  • Consider owning a fund that has the flexibility to buy futures contracts of various lengths (one month, three months, six months, 12 months) instead of just the next month, since contango can differ with the length of the contract.
  • Be aware of the potential for other investors to trade ahead of very, very large funds and consider funds that are not quite so large in size.

The final common structure is the exchange-traded note (ETN). ETNs aren't ETFs, but investors sometimes consider them alongside ETFs—the blanket term is "exchange-traded products." There are many commodity-based ETNs, tracking everything from broad commodity indexes to individual agricultural products and metals.

ETNs are designed to deliver the total return on a broad index or individual commodity, but rather than being structured as pools of securities that the fund itself owns, they are instead unsecured bonds (notes) issued by a firm that agrees to deliver the return of the index it tracks. Because of this, ETN investors need to be aware of the specific terms of the note and the credit risk of the issuer.

If the company offering the ETN goes bankrupt, holders of the ETN become creditors of the firm. In fact, when Lehman Brothers went bankrupt in 2008, shareholders of the three Lehman ETNs were left with securities that had become worthless.

Be cautious with ETNs—while they have the advantage of potentially delivering exactly the return of the underlying index with no tracking error, we think the credit risk is not worth shouldering, since similar products are generally available in a non-ETN structure.

What about ETFs that invest in commodity-producing companies?

Some ETFs primarily hold 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 tend to perform more in line with other stock ETFs than commodity prices. As a result, investors don't receive the sort of diversification benefit a true commodity ETF would provide.

Commodity ETFs that track indexes may be a sensible start

While some commodity ETFs track single products such as oil or gold, another popular choice (especially for investors new to commodities) is a diversified commodity index ETF, which is designed to give you exposure to a wide variety of commodities in a single investment.

The main commodity sectors in these indexes are energy (various oils, natural gas), metals (gold, silver, copper, nickel, aluminum, etc.), and agriculture (corn, soybeans, wheat, livestock, coffee, cotton, etc.).

There are several different commodity index ETFs and (although we think they're too risky for most investors) ETNs, varying for the most part in their exposure to energy. Here are some examples:

  • One of the most well-known commodity indexes is the Dow Jones-UBS Commodity Index (formerly the Dow Jones-AIG Commodity Index). This index is well diversified among 20 commodities currently, with 37% energy, 29% metals and 34% agriculture.1 However, the only fund that tracks it—iPath Dow Jones-UBS Commodity Index (DJP)—is an ETN, and worthy of caution due to its structure as a note.
  • The largest diversified commodity ETF by assets is PowerShares DB Commodity Index Tracking Fund (DBC), which tracks the DBIQ Optimum Yield Diversified Commodity Index. This index currently includes 14 commodities, with 55% energy, 22.5% metals and 22.5% agriculture. While the level of diversification is less than what the Dow Jones-UBS fund mentioned above offers, it is available in what we believe is the more favorable ETF structure. In addition, the index structure attempts to avoid the worst effects of contango to the degree that it can by selecting various dates of futures contracts.
  • Another well-known commodity index is the Standard and Poor's Goldman Sachs Commodity Index (S&P GSCI), which is tracked by both an ETF—iShares S&P GSCI Commodity-Indexed Trust (GSG)—and an ETN, iPath S&P GSCI Total Return Index (GSP). This index presently tracks 24 commodities but is highly concentrated in energy, with 69% energy, 10.5% metals and 20.5% agriculture.
  • The GreenHaven Continuous Commodity Index (GCC) is an ETF that tracks the Thomson Reuters Equal Weight Continuous Commodity Index (CCI), which sprang out of the older Commodity Research Bureau (CRB) Index. This index currently has 17 equal-weighted components, with 18% energy, 24% metals and 58% agriculture. The fund is newer than the funds above, having launched in early 2008, and has fewer assets. 
  • The United States Commodity Index Fund (USCI) is an ETF that tracks the SummerHaven Dynamic Commodity Index. Similar to the index tracked by DBC, this index attempts to minimize the impact of contango, though in this case the index will actually leave out commodities with the worst contango as needed. The index consists of 36% energy, 21% metals and 53% agriculture.
  • The final example on our list is the ELEMENTS Rogers International Commodity Index (RJI)—another ETN—which tracks the Rogers International Commodity Index. This fund has the most components, currently 37, and contains 44% energy, 21% metals and 35% agriculture. This fund also has the fewest assets of the diversified options.

Making the choice


So, how do you choose?

  • As mentioned we generally prefer ETFs over ETNs whenever possible.
  • Along with structure, another important consideration is the nature of the index. Are you looking for exposure to a single commodity or a broad index? How much exposure to each commodity sector are you looking for?
  • After deciding what type of index you're looking for, consider the characteristics of the fund itself. Look for ETFs with low expense ratios and high trading volume relative to other commodity ETFs, and avoid ETFs with extremely small asset bases.

How to take action

by the Schwab Center for Financial Research

Clients can find the information mentioned above and more by going to Exchange-Traded Funds on schwab.com or by using the ETF Screener. For a breakdown of a commodity ETF's components, consult the fund company's website.

Commodities are not for everyone. Carefully consider their particular risks and complexities before making an investment decision. If you decide that you seek the diversification and inflation- protection that commodities may offer, an ETF can be a relatively low-cost way to get exposure to this unique asset class.

While there are a wealth of options, from single-commodity funds to broadly diversified baskets, it's important to look carefully at all of the details of a fund, including its structure and its underlying index, before making the choice to invest. Also, for tax reporting purposes, keep in mind that commodity ETFs typically generate a schedule K-1 instead of a 1099 tax form.

 1. Index component weightings are taken from ETF and index provider websites as of September 2013.

Next Steps

The Trader's Toolbox: Technical Analysis
The Trader's Toolbox: Technical Analysis
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Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting schwab.com orcalling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

 

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