3 Things You Need To Know When Picking A Commodity ETF

by on March 4, 2013 | ETFs Mentioned:

Suppose that natural gas prices are on the rise and you’d like to capitalize. Like most retail investors, exchange-traded funds (ETFs) are probably the first thing that comes to mind, as they’re a lot easier to buy than commodity contracts. So, you decide to purchase a natural gas ETF that holds natural gas futures contracts of its own, in order to capitalize on this bullish investment thesis over the coming three months [Download 101 ETF Lessons Every Financial Advisor Should Learn].

Now, imagine that natural gas prices rise by 10% over this period, and you’re ready to sell and book the profit. After logging into your brokerage account, you’re surprised to see that the natural gas position has actually declined 5% in value over the same time frame! In this article, we’ll explore why this occurred as well as some other risks that investors should consider when picking a commodity ETF to purchase.

What’s in My ETF? Futures vs. Physically Backed ETFsCommodity Investing

Most ETFs come in two flavors, physically-backed or futures-based funds, and investors should understand the difference. Physically-backed (or specie) ETFs hold physical commodities designed to back up the value of shares issued, while futures-based (synthetic) funds use futures or swap contracts to provide exposure without any physical holdings. Deciding the ideal type to hold depends largely on the investor’s goals and risk preferences, expense ratio tolerance and discount/premium to the net asset value (NAV) price.

For example, shares of the SPDR Gold Trust ETF (GLD) represent fractional undivided ownership interests in a trust, which holds only physical gold bullion and, from time to time, small amounts of cash. The transaction costs associated with holding this trust are lower than the costs associated with purchasing, storing and insuring physical gold bullion with a 0.40% expense ratio. By comparison, synthetic gold ETFs like the PowerShares DB Gold Fund ETF (DGL) are composed of gold futures contracts, which may be more complex to manage and involve greater expenses, as reflected in this ETF’s 0.75% expense ratio [see Futures Free Commodity ETFdb Portfolio].

The difference between the two ultimately boils down to counterparty risk–the difference between being paid in cash or being paid with an IOU from a reliable friend. Critics of futures-based funds argue that counterparty risk is higher, since these funds only hold paper promising the delivery of gold, exposing investors to the risk of non-payment. But, while physically-backed ETFs may sound much more stable in comparison, many experts have warned that these funds routinely lend out securities to hedge funds and other institutions for short selling, which can result in counterparty risk of its own when these parties fail to cover.

The Issue of Diversity

Commodity ETFs focus on either one or multiple commodities or commodity classes, providing investors with a multitude of different options. Broad-based or family ETFs are those providing access to more than one commodity in varying percentages, while individual commodity ETFs tend to center on a single commodity or a pair of interrelated commodities that strongly correlate. Deciding on what ETFs to purchase depends largely on the investor’s investment thesis and desired exposure to any given commodity [see 17 ETFs For Day Traders].

Most broad-based ETFs tend to be overweight in energy holdings, like these popular options:

Ticker Symbol Fund Name Largest Allocation
DBC PowerShares DB Commodity Index Trading Fund 48% Oil and Gas
DJP iPath AIG Commodity Index Total Return ETN 10% Natural Gas
GSG iShares GSCI Commodity-Indexed Trust 70% Energy Assets
USCI United States Commodity Index Fund 29% Energy Assets

By comparison, agricultural ETFs tend to have an overweight position in a single commodity, like these popular options:

Ticker Symbol Fund Name Largest Allocation
DBA PowerShares DB Agricultural Fund 12.5% Corn
12.5% Soybeans
12.5% Sugar
12.5% Live Cattle
JJG iPath Dow Jones-UBS Grains Sunindex Total Return ETN 40.3% Soybeans
JJS iPath Dow Jones-UBS Softs Subindex Total Return ETN 49.4% Sugar

When it comes to commodity ETF asset allocation, always read the prospectus and ensure that the desired allocations are present. Sometimes, the names of commodity funds can be misleading when it comes to the actual components, especially broad-based commodity funds that tend to be overly focused on energy assets, and agricultural funds that are overweight in a single given commodity.

Contango Warning: Watch the Roll

Commodities ETFs that hold futures contracts–e.g. futures-based ETFs–also have a little-known additional risk that investors should carefully consider. Since futures contracts are finite in duration, fund managers must sell contracts that are close to expiration and replace them with new ones in order to avoid taking the delivery of billions of dollars of physical commodities. Worse, these transactions happen on a very predictable “roll schedule.”

These dynamics can cause a few problems for these funds and their shareholders. Given that these funds must purchase contracts on certain dates, they are exposed to the risk of overpaying for these contracts, either because of temporary market conditions or deliberate price manipulation. The former, known as contango, occurs when the price of a futures contract trades above the expected spot price of a contract at maturity. However, the latter involves professional traders and institutions that exploit the fact that fund managers must purchase contracts on a set schedule. For example, these traders can purchase contracts the next month ahead of the expected rolls to drive up the price, or sell before the fund managers in order to push down the price investors are paid for expiring contracts. Either way, shareholders in these ETFs can lose out in a big way [see also How Contango Impacts ETFs].

Physical vs. Futures Matters

Investors should be aware that commodity ETFs differ in many ways from equity ETFs. They can be either physically-backed or futures-based, be weighted with various asset allocations, and be subject to contango and other risks associated with their very operation. Keeping these things in mind, investors can avoid unnecessary risk and ultimately improve their risk-adjusted returns.

[For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven-day trial to ETFdb Pro.]

Disclosure: No positions at time of writing.