Types of Commodity ETFs

Types of Commodity ETFs

Types of Commodity ETFs - Risks & Benefits Of Investing In Commodity ETFs & How to Manage Risks With ETFsExchange traded funds have allowed common investors to reach out the parts of market that were previously inaccessible. Commodity asset class is a common example of such inaccessible part. Investing in commodity required special expertise and large capital investment.

Investment in commodity has been regarded as a rewarding option for investors willing to take calculative risks. It also offers investors to diversify their portfolio beyond bonds and stocks. Investing in commodity has been simplified with introduction of Commodity ETFs.

Spot price and future price

Commodity ETFs don’t work like bond or stock ETFs. Before investing in a commodity ETF you need to know whether it is tracking futures prices or spot prices. Spot price of a commodity is its current trading price. This price is often quoted in the news and it is the price that you have to pay for acquiring the commodity at that time.

Futures price is referred to the price that you need to pay today for receiving the commodity at a certain time (say after 3 months) in future. With such contract you are virtually locking the price of the commodity today.

Types of commodity ETF

In some cases the ETFs hold the physical commodity. This mostly happens in case of ETFs dealing with precious metals like gold and silver. Value of ETF will move with the spot price of commodity when the concerned commodity ETF is holding the physical commodity. The value of this type of ETF will also be affected by the security concerns of storing the valuable commodity.

Another type of commodity ETF holds baskets of future contract and don’t have any physical possession of concerned commodities. This type of commodity ETF structure is most commonly available. Different types of commodities ranging from crude to agricultural products and precious metals are used as commodities in this type of ETFs.

The commodity ETF holding futures contracts have to roll the contracts whenever they are close to date of expiry. It involves selling the old contracts before maturity and buying new ones for a future date. Returns from this type of ETFs is influenced by this type of continuous selling and buying contracts and popularly referred as roll yield.

Learning about roll yield

Roll yield is crucial factor for ETFs dealing with future contracts. In some cases the roll yield can be positive. This may happen with commodities having higher spot price and lower futures price. Let us assume spot price of a commodity is $100 and three months futures price is $90. It may happen when the market expects a fall in price of the commodity within three months. If you buy this contract and the spot price remains $100 when the contracts approach date of maturity, you can sell the contract at a price around $100. Clearly the roll yield is positive as the sell price of contract is higher than price of acquisition. The market is said to be in backwardation when the price of futures is lower than spot price. There are several commodities that have a normal tendency to trade in this way.

Roll yield can be negative when the price of futures contract is higher than the spot price. This happens when the market is expecting a rise in price of the commodity. It is the reverse case of backwardation. Assume that spot price of a commodity is $100 and you buy its three months future contract that is trading at $105. If the situation remains unchanged over three months period then you have to sell the contract at a price around $100. Obviously, you would be losing money in this deal. The market is said to be in contango when the price of futures is higher than spot price. ETFs dealing with futures contracts in this type of situation are losing money with each rollover. Return from an ETF suffers when the market or concerned commodities are in state of contango for a prolonged period. Relative return gets worse with deepening of contango.

Equity ETF

Other than future based and physical holding based ETFs there are equity based commodity ETFs. Some experts don’t categorize them strictly as commodity ETF. These funds hold equities of companies involved in production of various commodities. However, performance of such commodity ETFs may not have correlation with the underlying commodities. Investing in commodities like steel and coal may be done through such funds.

Equity based commodity ETFs are expected to provide a return of about 15% per year on long term investment. It is desirable to seek expert opinion before selecting such a fund and investing.

Managing risk

After learning about these risks of commodity ETF investment you may be worried about investing in it. However, there are solutions to manage and minimize the risk exposure and reap benefits from a booming commodity market.

Look for commodities that are in backwardation for sometime and study the current trend. Find a suitable commodity ETF dealing with futures of your selected commodities.

When the market is in contango you may change your attention to commodity ETFs that are holding the commodity in physical possession. Returns from ETFs having physical possession of commodity are not subjected by contango. However, such ETFs may not be available for every commodity.

The ETF having a balanced mix of longer and shorter dated contracts need to roll over less of its portfolio every month. Such ETF with wider spread of asset may be ideal for reducing impact of contango.

There are certain commodities ETF that are devised to reduce the shock of contango and take advantage of backwardation. This is done by tracking indexes and selecting future contracts with favorable roll yield.

It is desirable to diversify the investment across several commodities to minimize the risk. There are ETFs dedicated for a particular commodity, like gold ETF. While it has witnessed a healthy appreciation in last few years the scenario may not remain same in future.

Finally

Financial experts are increasingly recommending investors to include some commodities in their portfolio. Growing demand of commodities, rationalization of investment pattern, improvement in visibility and diversification of portfolio are some of the prime reasons for investing in commodity ETFs. An investor can allocate 5-10% of overall assets in commodity ETF depending on availability and risk appetite.

Acording with the Digital Millennium Copyright Act (“DMCA”), Pub. L. 105-304 If you believe that your copyrighted work is being infringed, notify our team at the email [email protected]

@[email protected] investments money

MORE ABOUT Types of Commodity ETFs