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.
Rationale for investing in commodities
Commodities are by definition basic products used as economic inputs. As a result, investing in essential items may be a sensible idea. Precious metals are employed as a store of value and an inflation hedge when it comes to some commodities.
The asset class of commodities often has a negative correlation with other asset classes like equities and bonds. As a result, commodities will appreciate when the value of equities and bonds declines, and vice versa.
They therefore provide investors with a useful tool to diversify their investment portfolio. Additionally, commodities provide protection from inflation.
Commodity ETFs as a solution
However, as it has historically been challenging to obtain direct exposure to commodities in a cost-effective and risk-acceptable manner, this is a concern for the majority of ordinary investors.
Investors can easily, affordably, and relatively safely gain exposure to specific commodities or baskets of commodities by using commodity exchange-traded funds (ETFs). Investors can create their ideal commodity exposure using one of the many ETFs that track various commodities, including basic metals, precious metals, energy, and agricultural products.
4 categories of commodity ETFs
There are 4 broad categories of commodity ETFs which each of those has both advantages and disadvantages. Investment decision is dependent on investors’ goals, objectives and risk tolerance.
Stocks in the firms that produce, transport, and store commodities are held through equity-based commodity ETFs. An equity-based commodity ETF can provide investors with exposure to a number of businesses or industry sectors, but in a quicker and less expensive way than purchasing the underlying businesses directly.
Due to the absence of the risks associated with physical and futures commodity ETFs, this may also be a cheaper and safer approach to commodities. Moreover, the expense ratios for the funds are typically lower.
The disadvantage of equity investment is that it adds a second barrier between the investor and the asset they want to get exposure to: the company structure itself.
Exchange-traded Notes (ETNs)
An exchange-traded note (ETN), a debt instrument issued by a bank, is the second kind of commodity ETF. It is a form of senior, unsecured debt that is backed by the issuer and has a maturity date.
ETNs use various tactics, such as purchasing stocks, bonds, and options, to attempt to match the returns of an underlying asset. The advantages of ETNs include better tax treatment because an investor only pays regular capital gains when the ETN is sold and no tracking error between the ETN and the asset it is tracking.
The credit quality of the issuing institution represents the primary risk associated with ETNs.
Physically Backed Funds
Physically backed ETFs, which are now only available in precious metals, actually have physical commodities in their possession. A physical ETF has the advantage of really owning and possessing the commodity. This eliminates counterparty risk as well as tracking risk.
When an ETF you own doesn’t deliver the same returns as the asset it is designed to track, you are exposed to tracking risk. Counterparty risk is the possibility that the seller will not actually fulfill their promise to deliver the good.
Physical commodities include costs associated with their delivery, holding, storage, and insurance; these prices can pile up. These are the drawbacks of this category.
Futures-based commodities ETFs are the most common type. The futures, forwards, and swap contracts on the underlying commodities are assembled into a portfolio by these ETFs. A futures-based ETF has the benefit of not having to pay for the holding and storage of the underlying commodity.
The majority of futures-based commodities ETFs follow a “front-month” roll approach, which has the benefit of closely tracking the commodity’s current, or spot, price.
The drawback is that because the front-month contracts that are about to expire are “rolled” into the second-month contracts, the ETF is vulnerable to “rolling risk.”
Most commodities ETFs that use futures are organized as limited partnerships. Taxably, 60% of the proceeds are treated as long-term capital gains, while the remaining 40% are subject to the investor’s standard tax rate.
Another factor to take into account is the fact that the LP’s gains are marked to market at the end of the year, which may result in a taxable event for an investor even if they haven’t sold any of their shares in the ETF.
Examples for best commodity ETFs traded in the market
Precious metals, oil, and natural gas are a few of the underlying commodities that commodity ETFs monitor.
Other commodity ETFs, on the other hand, track a varied basket of commodities. Investors should always conduct their own research, but the following are some of the top commodity ETFs: Because the underlying commodity will never go bad or spoil, precious metal ETFs like gold and silver are very popular.
Two of the biggest gold and silver ETFs are the iShares Silver Trust and the SPDR Gold Shares. The cost ratios for the iShares Silver Trust are 0.50% and 0.40%, respectively, for the SPDR Gold Shares ETF.
Oil and natural gas are two more common types of commodity ETFs. These ETFs invest in futures contracts rather than the commodity itself because oil and gas cannot be stored like precious metals can.
The SPDR S&P Oil & Gas Exploration and Production ETF has an annual expense ratio of 0.35% and a diversified portfolio of 60 oil and gas producing companies.
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