What Every Investor Should Know About Commodity ETF Investing

by on March 10, 2010 | ETFs Mentioned:

It’s difficult to put a finger on the exact cause of the recent surge in popularity of commodity investing. More than likely, the boom is attributable to a number of different factors. Correlation between international equity markets (and even between stocks and bonds) has surged in recent years, increasing both the importance and difficulty of adding non-correlated assets to investor portfolios. Given the relatively weak correlation with other asset classes, commodities have found a home in many investors’ portfolios. Moreover, unprecedented injections of liquidity into the financial system have created anxiety over a coming uptick in inflation that could erode returns to stocks and fixed income instruments. Commodities have historically served as an effective inflation hedge, and many are once again turning to natural resources to protect assets from a surge in the CPI.

Regardless of the cause, commodity investing is hot, and many investors have turned to ETFs as a way to gain commodity exposure. There are three primary ways to gain exposure to commodity prices (as well as two spin-offs) through exchange-traded products, and each can potentially offer a very unique risk and return profile:

1. Physically-Backed ETFs

The most efficient way to gain exposure to changes prices of natural resources is to actually buy and hold the underlying commodity. Portfolios utilizing this strategy will ensure a near perfect correlation with the spot price of the commodity, since the value of the underlying holdings will move in unison with market prices. Unfortunately, the physical properties of many commodities make physical storage impractical or prohibitively expensive. The physically-backed exposure approach only makes sense for commodities that 1) are non-perishable, 2) are easily stored, and 3) maintain high value-to-weight ratios.

As such, the universe of physically-backed ETFs is essentially limited to precious metals funds that store bullion in secure vaults. Commodities available through physically-backed ETFs include gold, silver, platinum, and palladium.

2. Futures-Based Funds

While the physically-backed ETF structure works well for precious metals, a similar approach obviously wouldn’t work with the majority of commodities. A physically-backed livestock ETF would be a potential disaster for obvious reasons, while the storage costs and logistical headaches associated with a fund storing barrels of oil or bushels of wheat would likely necessitate a double digit expense ratio.

In order to provide exposure to prices of resources that don’t lend themselves to physical storage, many ETFs invest in futures contracts written on the related asset. A futures contract is an agreement to buy or sell a commodity at a certain date for a predetermined price, so its value generally moves along with spot prices. In order to avoid taking physical possession of the underlying commodities, these funds conduct a regular “roll” process, selling contracts nearing expiration and using the proceeds to purchase longer-dated futures contracts. As such, futures based products are impacted by three factors: 1) changes in the spot price of the underlying commodity, 2) interest earned on uninvested cash, and 3) the “roll yield” incurred when near month contracts are exchanged for longer-dated futures. If prices for future delivery are significantly higher or lower than the current price level, the third of these factors can contribute significantly to overall returns.

While the returns to futures-based commodity funds will generally exhibit a strong correlation with spot prices, the movements are often far from perfect. Perhaps the most extreme example is the United States Natural Gas Fund (UNG). In 2009, natural gas prices remained stable, but UNG (which implements a futures-based strategy) lost more than half of its value as a result of consistent contango in futures markets (see What’s Wrong With UNG?).

Funds utilizing a futures-based approach include UNG, the United States Oil Fund (USO), and PowerShares DB Commodity Fund (DBC).

2b. Futures-Based Commodity ETNs

Among exchange-traded commodity products relying on a futures-based strategy, there are some subtle, yet extremely important nuances. A number of commodity funds are actually structured as exchange-traded notes (ETNs) that are linked to futures-based commodity benchmarks. The UBS E-TRACS CMCI Food Total Return (FUD) is a good example. FUD is linked to the UBS Bloomberg CMCI Food Index, which measures the collateralized returns from a basket of 11 futures contracts from the agricultural and livestock sectors. FUD doesn’t actually invest in these contracts directly, but is rather a debt security that pays returns based on the movement of a related benchmark.

Commodity ETNs have both potential advantages and drawbacks. Because they don’t actually invest in futures contracts, ETNs will generally exhibit lower tracking error, and the management process may be more cost-efficient. But because ETNs are senior unsecured debt securities, they expose investors to the credit risk of the issuer. In the case of a bankruptcy, there are no underlying assets to be distributed to investors. Most ETN issuers maintain very high credit ratings, but the risk of default should never be completely written off.

Many of the commodity products offered by iPath and UBS are structured as ETNs.

3. Commodity Intensive Equities

Frustrated with the impact of contango on certain exchange-traded commodity products, some investors have turned to equities of commodity-intensive companies as an alternative means of establishing exposure to natural resource prices. Because the profitability of hard asset producers is often impacted significantly by the prevailing level of prices for the related commodities, a strong correlation generally exists between these assets. However, investors should remember that the holdings of these ETFs are not commodities, but stocks, and as such will generally exhibit a higher correlation with equity markets than spot commodity prices (thereby potentially diminishing one of the primary advantages of investing in commodities).

There are a handful of ETFs offering both broad-based exposure to asset producers (e.g., HAP) as well as more targeted exposure to gold miners (GDX, PSAU), agribusiness companies (PAGG, MOO), timber stocks (CUT, WOOD), and steelmakers (SLX, PSTL). A complete list of the ETFs included in the Commodity Producers Equities ETFdb Category is available here.

3b. IndexIQ ARB Global Resources ETF (GRES)

This ETF employs a unique investment strategy to offer exposure to commodity products, and as such is worthy of its own subset of the commodity-intensive equities heading. GRES invests in global companies that operate in commodity-specific market segments, but also includes short exposure to the S&P 500 and MSCI EAFE Index, essentially isolating the return component generated through movements in commodity prices (see a more in-depth look at GRES here).

Disclosure: No positions at time of writing.