Commodity ETFs: Know What You’re Getting Yourself Into

by on May 14, 2009 | ETFs Mentioned:

With the rapid declines in the equity markets over the past year and increasing worries about inflation, many investors have been looking for alternative ETF investments to reduce volatility in their portfolios and establish at least a partial hedge against deteriorating economic conditions. One of the most popular options for doing so has been commodity ETFs. But there is some confusion over what qualifies as a “commodity ETF,” with many resources expanding the definition to include ETFs holding equities of commodity intensive companies. 

The “Underlying” Issue

The most important characteristic to consider when evaluating a potential commodity ETF investment is the nature of the underlying assets held by the fund. It seems like a no-brainer - commodity ETFs hold commodities, right? Not always. Commodity ETFs can gain exposure to the movements in the prices of natural resources in two ways: (1) directly holding futures contracts on gold, silver, livestock, etc. and (2) indirectly holding commodities through the stocks of companies engaged in commodities businesses, such as mining companies, oil and gas equipment providers, and timber companies.

At this point, I should clarify that most of the “direct commodity ETFs” referenced above are actually structured as exchange traded noted (ETNs), since they invest primarily in futures contracts on the underlying commodities. While there are some differences between ETNs and ETFs, they generally function in the same way.

Advantages of Direct Commodity ETNs

For investors seeking inflation hedges through exposure to commodities, ETNs that invest directly in commodities (or commodity futures) are the best bet. These funds generally maintain a strong correlation with commodity prices, since arbitrageurs ensure that the prices of futures contracts on commodities (the core holdings of these funds) will move in line with the market price for the commodity itself. In this respect, direct commodity ETNs are the most effective hedging instrument for investors concerned with inflation.

The major disadvantage of direct commodity ETNs is the dismal long term outlook. A tremendous amount has been written about the fact that long term commodity returns are minimal, if not negative. Direct commodity ETNs may also have higher expense ratios than the ETF industry average. Since these ETNs gain exposure to commodity through futures contracts, they incur fees when contracts expire and new futures must be written. Since indirect commodity ETFs are generally (but not always) passively managed, they tend to have lower turnover and incur fewer trading fees.

iPath is one of the premier sponsors of direct commodity ETNs, with about 20 funds including:

  • iPath Dow Jones-AIG Agricultural Total Return Sub-Index ETN (JJA)
  • iPath Dow Jones-AIG Livestock Total Return Sub-Index ETN (COW)
  • iPath S&P GSCI Crude Oil Total Return Index (OIL)

Many iPath ETNs have an expense ratio of 0.75%.

Advantages of “Indirect” Commodity ETFs

Indirect commodity ETFs also have their advantages. Since the underlying assets of these funds are companies engaged in various commodities businesses, they maintain exposure to the equity markets, allowing greater upside during bull markets. In addition, indirect commodity ETFs typically maintain interests in dozens of companies, providing greater diversification than ETNs that hold only futures contracts on a single resource.

Increased correlation with the equity markets is also a disadvantage of indirect commodity ETFs for many investors. Since the holdings of these ETFs are equities, not commodities futures, their prices will vary from those of the commodities they are intended to track. These differences can occasionally be significant, resulting in a less effective hedge than intended.

Some examples of “indirect” commodity ETFs include:

  • Claymore/Clear Global Timber Index ETF (CUT):  Designed to track the performance of global timber companies.
  • iShares Dow Jones U.S. Basic Materials Sector Index Fund (IYM):  Holds chemical, mining, and metals companies.
  • iShares Dow Jones U.S. Oil Equipment Index (IEZ):   Designed to track the performance of oilfield services companies such as SLB and HAL.

The prices of the aforementioned ETFs will depend on the prices of the underlying equity securities, which, generally, will move roughly in line with commodity prices. However, these prices are also subject to influence from a variety of other factors that may result in significant tracking error relative to commodity prices.

Which is Right For You?

Which commodity funds are right for you ultimately depends on why your investment objectives. If you’re looking for an inflation hedge or making a speculative bet on commodity prices, iPath ETNs are probably optimal. If you’re looking for a partial hedge while maintaining exposure to equity markets, the indirect route may be more ideal.