A Beginner's Guide To Commodities Etf Investing

Investing in commodities is considered a risky move, but it can be an interesting diversification strategy. Commodity ETFs are a great way to get exposure to this asset class, as they are relatively low-cost, highly liquid, and tax-efficient. These funds can minimise transaction costs and mitigate risks associated with individual commodity or company performance.

Commodities like precious metals, oil, natural gas, and agricultural products are basic goods used as inputs in the economy. They are an asset class that is typically negatively correlated with stocks and bonds. When stocks and bonds decrease in value, commodities tend to increase, and vice versa. This makes commodities a good hedge against inflation.

There are several types of commodity ETFs, including equity ETFs, exchange-traded notes (ETNs), and physically backed funds. Each has its own advantages and disadvantages, and investors should consider their investment goals, risk tolerance, and cost tolerance when deciding which type of ETF to invest in.

When choosing a commodity ETF, it is important to consider factors such as the fund's size, cost, age, income, domicile, and replication method.

Commodity ETFs vs stocks and bonds

Commodity ETFs vs. Stocks and Bonds

Commodities are basic goods used as inputs in the economy that provide investment opportunities and may be used as a store of value and a hedge against inflation. Commodities are an asset class typically negatively correlated with other asset classes, such as stocks and bonds. When stocks and bonds decrease in value, commodities tend to increase in value, and vice versa.

Commodities, like precious metals, offer investors a way to diversify their investment portfolios. Commodity ETFs give ordinary investors easy and inexpensive access to various commodities markets. They are highly liquid securities that can be purchased on stock exchanges.

Commodity ETFs enable investors to gain exposure to individual commodities or baskets of commodities in a simple, relatively low-risk, and cost-effective manner. There are four main types of commodity ETFs:

• Equity ETFs: These invest in commodity-related stocks, such as companies that produce, transport, and store commodities. Equity funds can be a safer way to gain exposure to commodities, as they minimise the risks associated with physical and futures commodity ETFs.
• Exchange-Traded Notes (ETNs): ETNs are unsecured debt instruments issued by banks. They seek to match the returns of an underlying asset, such as stocks, bonds, or commodities, by employing different investment strategies. ETNs have better tax treatment than other options, as investors only pay regular capital gains when the ETN is sold. However, the main risk involved with ETNs is the credit quality of the issuing institution.
• Physically Backed Funds: These ETFs hold physical commodities, usually limited to precious metals. The advantage of physical ETFs is that they remove tracking and counterparty risk. However, the disadvantage is the cost of delivering, holding, storing, and insuring physical commodities, which can be high.
• Futures-based Commodity ETFs: These ETFs invest in futures contracts of commodities, such as oil and natural gas. They pursue a "front-month" roll strategy, holding futures closest to expiration and then rolling them over into the next month's contract. This strategy closely tracks the spot price of the commodity but exposes the ETF to "rolling risk".

Commodity ETFs can be a useful tool for investors who want access to commodities but want to limit their exposure and manage risk. They are often used to hedge against inflation or rising commodity prices. However, it is important to note that commodity ETFs carry risks and are not a guarantee of profit.

Compared to stocks and bonds, commodities themselves don't generate cash flows like the companies that produce them. This means that investing in commodities is a bet on price movement, which can be difficult to predict consistently. As such, investors should adjust their expectations and be cautious about paying too much for their exposure.

Commodity ETFs provide a simple way to gain exposure to commodities without the complexities of the futures market or the hassle and costs associated with storing, insuring, and transporting physical commodities. They offer diversification and a hedge against inflation, making them a valuable addition to an investment portfolio.

Pros and cons of commodity ETFs

Commodity ETFs are a great way to diversify your portfolio and hedge against inflation. They are also a simple, relatively low-cost, and tax-efficient way to gain exposure to commodities. However, they do come with some risks and potential drawbacks.

Pros of Commodity ETFs:

• Diversification: Commodities behave differently from stocks and bonds, so investing in commodity ETFs can help reduce risk by diversifying your portfolio.
• Inflation Hedge: Commodities are a good hedge against inflation, especially unexpected inflation.
• Easy Access: Commodity ETFs offer an easy and inexpensive way for ordinary investors to gain exposure to various commodities markets.
• Low Cost: Commodity ETFs provide a low-cost way to access asset classes that might otherwise be difficult to invest in.
• Tax Efficiency: Commodity ETFs are taxed differently from direct commodity investments, which can result in more favourable tax treatment. For example, holding periods for commodity ETFs can impact tax rates, with lower rates for long-term holdings.
• Liquidity: Commodity ETFs are highly liquid securities that can be easily bought and sold on stock exchanges.

Cons of Commodity ETFs:

• Volatility: Investments in commodities can be volatile. Allocating a significant portion of your portfolio to commodities may reduce the diversification benefits.
• Futures Exposure: Investing in futures-linked commodities carries the risk that the price will not directly trade or perform as expected. Commodity futures-linked products may also be impacted by market conditions such as contango and backwardation.
• Tracking Discrepancies: Futures-backed funds and exchange-traded notes (ETNs) may not always accurately track the underlying commodity due to regulatory and tracking risks.
• Credit Risk: ETNs carry the risk of the creditworthiness of the issuing institution.
• Regulatory Risk: Futures-backed funds and ETNs may be subject to regulatory restrictions on their involvement in the futures market, which can impact their performance.
• Limited Physical Holdings: Some commodities, such as oil and gas, cannot be stockpiled, so ETFs in these sectors invest in futures contracts rather than the physical commodity.
• High Expenses: Futures-based commodity ETFs incur higher expenses due to the constant rollover of futures contracts, and expense ratios can vary across funds and commodities.

Types of commodity ETFs

There are four main types of commodity ETFs:

• Equity ETFs: These invest in the stocks of companies that produce, transport, and store commodities. This type of ETF offers exposure to multiple companies or sectors in a simple and inexpensive way. Equity funds can also be a safer way to gain exposure to commodities, reducing the risks associated with physical and futures commodity ETFs.
• Exchange-Traded Notes (ETNs): ETNs are debt instruments issued by banks. They aim to match the returns of an underlying asset, such as commodities, by employing strategies like buying stocks, bonds, and options. ETNs have better tax treatment than other ETFs, but the main risk is the credit quality of the issuing institution.
• Physically Backed Funds: These ETFs hold physical commodities, usually limited to precious metals like gold and silver. The advantage is that they eliminate tracking and counterparty risk. However, the costs of delivering, holding, storing, and insuring physical commodities can be high.
• Futures-Based Commodity ETFs: These ETFs invest in futures contracts on commodities. They avoid the costs of holding physical commodities but may face "rolling risk" when replacing expiring futures contracts with longer-dated ones. Most futures-based commodity ETFs are structured as limited partnerships for tax purposes.

How to invest in commodity ETFs

Commodity ETFs, or exchange-traded funds, are a low-cost way to access asset classes that might otherwise be difficult to invest in. They are a great way to diversify your portfolio and act as a hedge against inflation.

Commodities are basic goods used as inputs in the economy, such as agricultural goods, natural resources, or metals. They are an asset class that is typically negatively correlated with other asset classes like stocks and bonds. This means that when stocks and bonds decrease in value, commodities will increase, and vice versa.

There are four different types of commodity ETFs:

• Equity ETFs that invest in commodity-related stocks
• Exchange-Traded Notes (ETNs)
• Physically backed funds
• Commodity futures

• Open an investment account: This is where your investments and the money you plan to spend on them will live. Some investment accounts offer significant tax benefits, so it's important to choose the right type of account for your needs.
• Research commodity ETFs: Use the screening tools provided by your online brokerage account to search for commodity ETFs. Compare expense ratios, volume, holdings, and performance to help narrow down your options.
• Purchase the commodity ETF: The process for buying commodity ETFs is similar to buying stocks. Navigate to the "trading" section of your brokerage website and search for the ETF by name or ticker symbol. Then, enter the number of shares or the dollar amount you wish to purchase.

• Energy Select Sector SPDR Fund (XLE): This ETF offers indirect exposure to energy by investing in the largest oil companies. It has over $38 billion in total net assets and an extremely low expense ratio of 0.10%.
• IShares Gold Trust (IAU): This ETF offers exposure to physical gold, which is impractical for individual investors to buy and sell. IAU has $25.7 billion in total net assets and a low expense ratio of 0.25%.
• SPDR Gold Shares (GLD): This is one of the best-known gold-backed funds and has proven to be a popular way to invest in gold without the complexities of the futures market or the hassle of storing and insuring gold. GLD has $56.2 billion in assets under management and an expense ratio of 0.4%.
• Invesco DB Commodity Index Tracking Fund (DBC): This ETF offers exposure to a wide range of commodities across the energy, metals, and agricultural sectors. It is rebalanced annually and provides investors with a cost-effective and convenient way to invest in commodity futures.
• Invesco DB Agriculture Fund (DBA): This ETF offers exposure to the agriculture space and has been around since 2007. It has decent liquidity, with roughly 388,000 shares of average daily trading volume over the past three months.

Remember to consider your investment goals, risk tolerance, and cost tolerance when choosing a commodity ETF. Also, keep in mind that commodities can be volatile, so allocating more than 5%-10% of your portfolio to commodities may reduce the diversification benefits.

Commodity ETFs and inflation

Commodities are basic goods used as inputs in the economy, and they can be used as a hedge against inflation. They are an asset class that is typically negatively correlated with other asset classes like stocks and bonds. When stocks and bonds decrease in value, commodities increase, and vice versa. Commodities like precious metals also offer investors a way to diversify their investment portfolios.

Commodity ETFs give ordinary investors easy and inexpensive access to various commodities markets. They enable investors to gain exposure to individual commodities or baskets of commodities in a simple, relatively low-risk, and cost-effective manner. There are four different types of commodity ETFs: equity ETFs that invest in commodity-related stocks, exchange-traded notes (ETNs), physically backed funds, and futures-based commodity ETFs.

• SPDR Gold Shares (GLD)
• Market Vectors Junior Gold Miners ETF (GDXJ)
• Van Eck Market Vectors Hard Assets ETF (HAP)
• IShares Gold Trust (IAU)
• Invesco DB Agriculture Fund (DBA)
• Global X Uranium ETF (URA)
• IShares S&P GSCI Commodity-Indexed Trust (GSG)

Frequently asked questions