Commodity ETF (Exchange-Traded Fund) and FAQs 

A commodity ETF is an exchange traded fund (ETF) that invests in real commodities like raw materials for manufacturing, agricultural products, and precious metals. A commodity ETF typically focuses on either investments in commodities futures contracts or holdings of a single commodity in physical storage.

It’s crucial to comprehend the fund’s strategy before investing in any fund, especially in those that track commodities. Here are three questions to make when looking into commodity exchange-traded funds (ETFs) for your portfolio.

Does the commodity ETF hold futures or physical assets?

The majority of commodities, such as wheat, oil, and animals, are too expensive or difficult for an ETF to transport and store. 

ETFs usually invest in these commodities through futures contracts, which are agreements to purchase a commodity at a future date for a predetermined price with the goal of exiting the contract before it expires as opposed to taking ownership of the commodity in question.

However, some precious-metal ETFs actually buy the real assets, such as gold or silver bars, and store them in secure vaults. Because the metals can be retrieved and sold at any moment on the spot market, these ETFs frequently follow the spot price of the underlying commodity.

As a result, ETF managers must frequently sell contracts that are about to expire and buy new contracts with longer expiration dates, which could have the following two effects:

• ETFs are effectively selling high and buying low with each contract rollover when backwardation occurs, which occurs when contracts that are close to expiration have higher prices than contracts with expiration dates further away. When the current demand for a commodity is higher than what market participants anticipate it to be in the future, in relation to the supply, this occurs.
• Contrarily, ETFs effectively sell low and buy high with every contract rollover when contracts that are close to expiration have lower prices than those with expiration dates further out—a situation known as contango. This occurs when, compared to the supply, the current demand for a commodity is lower than what market participants anticipate it to be in the future.

Is commodity ETF volatile?

Due to the supply-and-demand characteristics of their underlying assets, which can be significantly impacted by particular events, commodity ETFs are notably volatile. For instance, unseasonably cold or wet weather can have disastrous effects on various agricultural commodities, while OPEC can improperly affect oil prices.

ETFs that follow a broadly diversified commodity index could be one solution to this potential issue. However, the level of diversification will differ by index. For instance, the S&P GSCI Commodity Index allocates 61.5% of its weight to the more volatile energy sector1, compared to 29.9% for the Bloomberg Commodity Index. 

What is its tax treatment?

Commodity ETF complications may lead to uncommon tax problems. According to American tax law, funds that directly possess precious metals are taxed as collectibles. The tax bill for this investment could exceed the long-term capital gains rate or even your ordinary income tax rate, depending on your income tax bracket.

On the other hand, funds that engage in futures and other derivatives contracts may be set up as partnerships, which results in you receiving a K-1 tax form at the end of the year rather than the standard 1099. 

Some more recent funds pass their investments through an offshore business, allowing the fund to be taxed similarly to a conventional mutual fund, in order to avoid the difficulties and extra costs K-1s can bring about at tax time. 

It’s crucial to keep in mind that these funds might be actively managed and might provide less insight into their underlying holdings.

Your long-term portfolio can benefit from diversification and inflation protection by investing in commodity exchange-traded funds (ETFs). The construction of the ETF you are examining is important if you are trying to make shorter-term tactical changes, though, as a fund’s volatility, in particular, can have a significant impact on your short-term prospects.

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