How to use ETFs to invest in commodities

  • By Simon Constable,
  • Barron's
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Commodities are soaring this year, reminding investors of their potential to fortify a portfolio. The S&P GSCI commodity index (.SPGSCI), which follows a basket of commodity prices, including crude oil, industrial metals, precious metals, and foodstuffs, gained 15% in the first quarter, versus 13.1% for the S&P 500 index (.SPX).

If you’re looking to increase your exposure to the asset class, consider doing so through exchange-traded funds instead of playing the futures market—or by purchasing physical bars of bullion. ETFs are simple, and they can help reduce overall risks and add to returns.

The primary reason for owning commodities is not to beat stocks so much as to hold assets that may zig when stocks zag. “Commodities are used for diversification, as they have a low correlation to stocks and bonds,” says John Love, CEO of ETF firm USCF Investments in Walnut Creek, Calif.

Adding commodities should lower risk but shouldn’t hurt overall portfolio returns. “If you look at broad-basket commodity ETFs, over the long term, they have similar returns and similar volatilities” to stocks, Love says. And commodities are also a good hedge against the wealth-withering effects of inflation, he says.

During the high-inflation 1970s, while stocks languished, gold jumped from $35 a troy ounce in 1971 to a high of $850 in 1980. Barron’s Andrew Bary made a bullish call on gold last September with a similar inflation-beating thesis.

How much commodity exposure is enough? Love says 5% to 15% of the value of a portfolio is a good starting point for most investors. More than that typically doesn’t bring better diversification.

While investors have long had access to commodities futures directly, ETFs don’t need to be monitored as closely. Likewise, the buyers of ETFs that hold bars of precious metals, such as SPDR Gold Trust (GLD), don’t need to worry about secure storage vaults or insurance.

“[Most investors] only want exposure to price changes. They are more comfortable with ETFs,” says Jeffrey Christian, managing director of commodity consulting firm CPM Group in New York.

Funds that hold futures contracts can sometimes suffer from so-called contango, or the cost of rolling forward expiring futures contracts. If nearby futures prices are lower than long-dated ones, you have contango. This effect waxes and wanes, but can eat into profits if the prices of the underlying commodities stand still.

At the time of writing, there is no contango in oil futures, so that doesn’t hamper the United States Oil fund (USO), which holds futures contracts for light sweet crude oil. Crude-oil ETFs don’t usually hold physical oil.

Game of indexes

Commodities indexes are not all the same. That’s why it is important to look at precisely what you are buying when you get an ETF that tracks such an index, says Hakan Kaya, senior portfolio manager of the actively managed Neuberger Berman Commodity Strategy fund (NRBAX).

Some indexes weight the different commodities according to the production level of each material or foodstuff. “If more is produced, it is weighted more,” he says. For example, 63% of the holdings of the S&P GSCI commodity index are in energy, such as crude oil and gasoline. The remainder is made up of agricultural products (such as coffee and wheat), livestock (hogs, cattle), precious metals (gold), and industrial metals (aluminum).

That means the performance of the iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) is highly dependent on energy prices. Contrast that with the Invesco DB Commodity Index Tracking ETF (DBC). It is based on a different commodity index, which has a 44% exposure to energy. You might prefer that fund if, for instance, you have exposure to energy stocks elsewhere in your portfolio.

Keeping costs down

As with all investing, keeping your costs low is vital. “We go with ETFs that have lots of volume and low costs,” says Richard Rosso, director of financial planning at registered investment advisor Clarity Financial in Houston.

The iShares S&P GSCI and Invesco DB ETFs have annual expenses of 0.75% and 0.85%, respectively. Their respective average daily volumes are 652,000 and 2.1 million, according to Morningstar. Some commodity ETFs have very low volume, with fewer than 30,000 shares trading a day on average.

While the expense levels of the iShares and Invesco funds might seem high compared with a large-cap stock fund such as the SPDR S&P 500 ETF (SPY)—which charges 0.09%—they are reasonable for the commodity sector, says Rosso. And the hefty volume also helps keep other costs lower.

When picking a fund, it’s worth finding out whether there are commission waivers, Rosso says. That can also help reduce costs and may help offset differences in annual expense charges.

In addition to being able to dump large positions quickly without moving the price the wrong way, more trading volume typically means tighter bid-ask spreads. Both factors result in lower costs.

High fund expenses, from whatever source, eat into returns over time, and illiquid funds incur higher bid-ask spreads when buying or selling their holdings.

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