What is a Commodity ETF?
A Commodity ETF is an Exchange Traded Funds (ETF) that invests in commodities such as agricultural products, precious metals, natural resources, etc. Commodity ETFs invest in commodity futures contracts or a specific commodity held in physical storage.
On the other hand, other commodity ETFs track the performance of a wide commodity index that comprises of a variety of individual commodities.
These ETFs are popular among traders and aggressive investors looking to hedge against inflation or profit from a falling stock market. Like any other investment, these ETFs come with risk and do not guarantee returns. Furthermore, commodity ETFs offer investors exposure to commodities without having to worry about purchasing futures or derivatives contracts.
How do Commodity ETFs Work?
Commodity ETFs are highly liquid schemes, and you can easily trade them on the stock exchange. These ETFs invest in commodities such as precious metals, natural resources, gold, oil, and maze rather than equities or bonds. These ETFs often obtain exposure to commodities through futures, but they may also hold physical commodities. Commodity ETFs are popular because they simplify investors’ investments in commodities. It is often difficult to trade in commodity futures.
Commodity exchange-traded funds are asset-backed or futures contracts that track the performance of a single commodity or a group of commodities. These contracts represent the commodity and track its performance. Investing through these exchange-traded funds doesn’t give the actual ownership of the commodity. For example, you are not purchasing gold bars when you buy a Gold ETF. You are only investing in a gold-backed exchange-traded fund (ETF).
When other asset classes, such as equities and bonds, do not perform well, commodities can be good alternative investments. Commodities and equities, and bonds have a negative correlation. Thus, these ETFs offer good diversification.
Who Should Invest in Commodity ETFs?
Investing in this ETF doesn’t give physical asset ownership. Rather, you own the set of contracts that the commodity backs.
Most investors buy commodities to diversify their portfolios or for tactical reasons during periods of high volatility or uncertainty in the economy. Some commodities, such as oil, are highly correlated with economic health, but others, such as gold, are not.
If you are an investor looking for diversification across asset classes, then you can consider investing in these ETFs. However, it is essential to understand the objective of a commodity ETF before investing in one. Since commodities have a negative correlation with equities and bonds, they can be good hedging investments for advanced investors who know what they are doing.
Furthermore, these ETFs are low-cost investment options to invest in asset classes that would otherwise be difficult to access. Also, if you are bullish towards certain commodities or believe that innovation will boost the commodity’s demand. You can invest in the commodity ETF that tracks it.
Things to Consider as an Investor
Following are the things to consider while investing in commodity ETFs:
Understand the investment objective of the commodity ETF before investing in them. When selecting a commodity ETF, you should have a clear investment strategy in mind. Choosing the right commodity exchange-traded fund that aligns with your investment purpose is critical.
Historical performance doesn’t guarantee future returns. Commodity prices can be highly volatile. However, analyzing the performance and studying the commodity movements over time will help you understand their sensitivity to external factors.
These ETFs are high-risk investment options. Markets can be in contango or backwardation. Contango is when the futures contract prices are higher in the futures market than in the spot market. While in a backwardation, the current price of a commodity is greater than the future price.
The rolling risk is ‘ negative’ when a futures market is in contango. It means the commodity ETF will sell lower-priced futures that are due for expiry and buy higher-priced futures. Thus, resulting in a negative roll yield. Buying higher-priced futures will lower overall returns.
Hence it is important to consider the risks associated with investing in these ETFs before investing in one.
Commodity funds provide a low-cost and convenient way to access the commodities market. You can easily invest in commodities without having to worry about purchasing futures or derivatives contracts. Which otherwise would be tedious and expensive.
Advantages of Commodity Exchange Traded Funds
Following are the advantages of investing in commodity ETF funds:
- Real-Time Prices: These ETFs are listed on the stock market. Thus you can buy and sell them at any time during the trading hours.
- Low Cost: These ETFs are low-cost investment schemes. Investing in commodities can be expensive and time-consuming. Furthermore, it requires experience in dealing with futures and derivatives contracts. Since commodity ETFs track a commodity index, it is a passively managed fund. Hence, the cost of fund management is low when compared to actively managed schemes.
- Diversification: These ETFs can offer good diversification to your investment portfolio. These ETFs give exposure to commodity contracts that are backed by gold, oil, gas, precious metals, agricultural products, etc.
- Hedging: Since commodities have a negative correlation with equity and bonds, they are good for hedging.
- Passively Managed Funds: These ETFs are passively managed schemes. The funds aim to track the price movements of the underlying commodity closely.