A commodity ETF is an exchange-traded fund (ETF) invested in physical products such as natural resources, agricultural goods, and precious metals. They are primarily focused on a single commodity held in physical storage and sometimes in investments in commodities futures contracts.
There are commodity ETFs that track the performances of a broad commodity index that includes a combination of derivatives position and physical storage.
Commodity ETFs are great for investors trying to hedge against inflation or looking to make a profit when the stock markets are stumbling. However, to keep in mind that commodity ETFs are the same as any other form of investment. It carries a risk of loss and does not always guarantee a profit.
How Do ETFs Work?
Exchange-Traded Funds are bundles of different securities, including bonds, stocks, or physical commodities listed on a stock exchange. ETFs track stock indices such as the Straits Times Index (STI) or the S&P5 500 index.
ETFs are traded almost the same as stocks sold on the open market. The best part of investing in ETFs is that they are well-diversified across different geographical regions and industries hence offering much-needed portfolio diversification for investors.
You can also purchase ETFs with supplemental retirement schemes (SRS) funds or cash. You can easily purchase ETFs through a brokerage account which is quite convenient.
What is a Commodity ETF?
Commodity ETFs have gained a lot of interest in the recent past. Commodity ETFs are exchange-traded funds that expose investors to changes in prices of raw materials such as metals, agricultural goods, and other natural resources.
These ETFs are structured in one of the following ways:
These ETFs can buy and store physical commodities themselves. Examples include iShares® Gold Trust (IAU) and SPDR® Gold Shares (GLD). They are trusts that use their assets to buy gold bullion to store in the banks’ vaults.
This structure is in the form of future contracts. They are traded the same as bonds and stocks and do not require a physical commodity.
What are the Different Types of Commodity ETFs?
Here are some of the common types of commodity ETFs available:
• Grantor Trusts
Here you will invest in a physical commodity such as silver and gold bar stored in secure vaults.
• They are Actively Managed
Some ETFs can invest in commodity futures to avoid distributing K-1s among investors holding future contracts in the Cayman Islands subsidiaries.
The Cayman Islands trusts to invest in commodity futures contracts and other derivatives on behalf of the funds.
• Limited Partnerships
Limited partnerships invest in commodity futures. A commodity future contract is a document that details when you are to receive a particular commodity for the price agreed upon.
Investors with this type of investment receive K-1s at tax time.
• Commodity Producers
Some ETFs only hold specific commodity-producing companies such as oil drilling and gold-mining firms.
The performance of such companies does not depend on the commodity price, and they mostly perform in the line of other stock ETFs than the commodity pricing.
• Exchange-Traded Notes (ETNs)
ETNs promise the issuer to repay the face value and the return on a referenced commodity index while deducting the fees.
ETNs are debt notes and are not secured by any underlying assets or securities; this means that the issuer’s creditworthiness should be constantly monitored.
It is essential not to allow the ETN issuers to accelerate the redemption of certain ETNs at their discretion. Moreover, the issuer can also delist the ETN from the national exchanges and suspend new issuance.
Why Invest in a Commodity ETF?
Investing in commodity ETFs gives the average investor affordable access to various commodities in the market. Many investors are always advised to hold some portion of the portfolio in the commodities to diversify their investments and hedge against inflation.
Pros of Investing in Commodity ETFs
Diversification of Your Portfolio
Commodities are relatively different from other asset classes, giving you a chance to diversify your investment portfolio. The main drivers of commodities are the global supply and demand forces that differ from stocks.
They offer a way for investors to gain exposure to one or more commodities while reducing the investment risk.
For example, the price trends in stocks and commodities may differ in a crisis. Stocks’ prices may reduce while the commodity prices may skyrocket. However, note that the prices of stocks are not resistant to business cycles.
Hedges You Against Inflation
Inflation refers to the change in the prices of goods over time. This means that investors have to consider it while investing their money. In most cases, your investments will not keep up with inflation.
To counter this factor, your investments should always keep up with the rise of prices, and commodities will do that for you.
Cons of Investing in Commodity ETFs
High Market Volatility
Commodities are known to be the most volatile classes asset around. This is mainly because the main driver of the commodities is a balance between supply and demand. There are periods when there is a severe imbalance between the two which causes significant swings in prices.
Commodities do not generate incomes as fixed income investments and other financial instruments. They do not pay any dividends or interest. Commodities’ total profit or loss is only dependent on the market price appreciation or depreciation of the underlying prices of the asset.
How Do You Buy Commodity ETFs?
If you want to invest in commodity ETFs, you will need a brokerage firm to purchase the security. You will buy your commodity ETFs the same way you buy stocks.
You will need to look for the ticker symbol of the commodity exchange traded funds, then place a purchasing order and receive the security when your purchase is complete.
Most investors can complete their purchases immediately since the liquidity is relatively high with commodity ETFs.
Which are the Best Commodity ETFs?
Choosing the best commodity ETF is determined by the risk tolerance and the investment goals of the investor purchasing them.
For example, one investor could benefit from a 3X Crude Oil ETF while another investor could find the risk too high for their investment strategy.
However, most investors use silver and gold ETFs to hedge inflation which is among the top commodity ETFs trading.
Which is the Best Commodity ETF for a Buy and Hold Investor?
The investor model will also determine the best commodity ETF for a buy-and-hold investor and if it matches their risk tolerance.
Commodity ETFs are also traded regularly; therefore, the commissions and management fees, also known as expenses rations, might be relatively high for a buy-and-hold investor.
Therefore, the best commodity ETF for any investor will be one that charges a low management fee.
Commodity ETFs are important for investors who want access to commodities but want exposure while managing their risk. Most investors use commodity ETFs to hedge against inflation and find them easy to trade, making them attractive investments.