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Using ETFs to invest in commodities

  • Wiley Global Finance WILEY GLOBAL FINANCE

Over the last few years, growth in the commodity ETFs has been astounding. Various structures are providing exposure to an asset class that had been difficult to access for many investors. Within the category you can obtain broad or narrow exposures to single commodities or baskets of commodities. Some products are even attempting to actively manage baskets of various commodities based on different strategic trading models and various factors.

The products fall into three main categories of commodities:

  1. Agriculture
  2. Energy
  3. Metals

But within these categories are many variations of products offering different combinations of exposures. ETFs use several methods for providing exposure to commodities. These include holding:

  • The physical commodity
  • Futures tracking a single commodity
  • Futures tracking baskets of commodities
  • Equities with exposures to commodities in various forms

The funds holding various baskets of equities will be exactly like any other Investment Company Act of 1940 ETF with either domestic or international holdings. They utilize various weighting schemes to provide exposures via equities to companies that have commodity-related activities.

Futures-Based Funds

Beyond the equity-based funds are funds that utilize futures, swaps, or other derivatives to attain their desired exposures. There are two effects to consider when using commodity funds with futures as the underlying:

  1. The potential effects of position limits due to either the notional size of fund holdings or regulatory concerns
  2. The potential effects of rolling those futures' positions

The expanding size of futures-based funds and their size relative to the underlying markets that they track led to a market review, in the summer of 2009, by the Commodity Futures Trading Commission (CFTC) about their potential influences within the commodities markets.

A commodities futures contract is a standardized contract to buy or sell a commodity at a specific date in the future based on a price agreed to today. Important to note is that futures have an expiration date at which point the contracts expire; then you have to deliver either the underlying asset or cash, depending on the specific futures contract you have positioned. A fund holding futures will have to roll those positions at every expiration date. This is necessary so that the fund does not lose its exposure to its underlying asset class. In order to roll your futures position, you would have to sell the contract you hold (called the near-month contract) that is about to expire and buy the next-period contract that is available (the far-month contract). Because of this periodic selling of the near contracts and buying of the far contracts, futures-based funds sometimes can be subject to the effects of backwardation or contango.

Backwardation is a condition in the futures market where the future contract price is lower than the spot price, which is essentially the value of the expiring near contract. The opposite condition is contango, where the futures contract price is higher than the spot price. These two conditions of the marketplace can cause performance variations in the ETF NAV relative to its benchmark. It is important to look closely at what the funds are doing and read each prospectus. It is important to know how funds handle these conditions in the futures markets and what effects they possibly can have on the fund's performance.

Physical Commodities

The biggest physically backed gold ETF in the world is the SPDR Gold Trust. At the end of November 2011, this fund held more than $72 billion in assets reflected as a holding of approximately 41 million ounces of gold.

Storage costs are probably the most important consideration of the ETFs that hold physical commodities. It is relatively easy to hold gold bullion as compared to similar notional amounts of natural gas, which is why certain funds are based around derivatives and others are not.

The physical commodity funds in general are reasonably easy to value. On the Web page of the Gold Trust, for example, you can see the actual holdings of ounces of gold and the number of shares outstanding on a daily basis. When calculating the value of the fund, you would calculate a real-time value for the gold held by multiplying the number of ounces by the most recent mid-price of gold bullion. Then you would divide that number by the number of shares outstanding. This would give you a value before expenses of the gold in the trust in share terms.

An important facet to understand when investing in the commodity funds is taxation. In the case of the Gold Trust, gold is treated as a collectible for long-term capital gains purposes. If held for more than a year, individuals will be subject to a capital gains rate of 28%. According to the Gold Trust Web site, it also received a private letter ruling permitting investment by retirement plans. This is not tax advice; it is important to determine your own situation regarding taxes through discussions with your accountant.

Article copyright 2011 by David J. Abner. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange Traded Funds with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

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