Commodities ETFs are financial securities that track the price of a single commodity or any basket of commodities. Most commodity ETFs include only one type: gold or oil. Still, ‘commodity’ ETFs allow investors to buy into an entire stock market in a specific country (such as Australia).
Two types of common and popular commodities
Physical commodities and futures contracts can be challenging to tell apart at first glance. It’s easier for newbies if we use an example: consider investing in gold through a fund like this.
An investor will either buy actual bars of gold (physical) or invest their money into derivative instruments such as futures, essentially making bets with other investors on whether the price of gold will rise or fall. Tracking a physical commodity ensures that you reap the benefits of any harvests or yields caused by favourable climate conditions, changes in government policy, etc.
However, investing directly into a futures contract allows for more flexibility and is usually seen as ‘safer’ because it involves less upfront investment.
You might also come across some funds that don’t track a physical commodity but merely provide exposure to an index like GSCI (Goldman Sachs Commodity Index). These indices are designed to have low volatility and high returns through diversification with similar commodities. So although your gains from investing in these won’t be magnified like they would if you invested indirect ownership of the commodity, they will still provide consistent and reliable returns.
Gains on commodities ETFs can either be realised or unrealized
It means that investors get to keep all of the profits on their ETF or some of it. This depends upon whether the commodity’s price has risen since you bought into it. For example, suppose you own a French GDP index tracker, and the economy crashes. In that case, that particular index’s value decreases – but you won’t lose any money as long as you made your initial investment at a time when GDP was worth more than what you paid for it (i.e. it wasn’t trading at an all-time high). However, this doesn’t matter with un-leveraged funds because holding onto the ETF means you always maintain your exposure to the underlying commodity.
Leveraged ETFs are a different story – these funds amplify the gains and the losses on an investment. So if I owned 1 unit of a leveraged oil fund and the price of oil went up by 10%, that fund would be worth 11 units. However, if the oil price fell by 10%, that same fund would now be worth less than nine units. It’s because a leveraged ETF aims to provide 2x or 3x the return of the underlying commodity.
There are two main types of commodities ETFs
Physically-backed and futures-based. Physically-backed ETFs track physical commodities, while futures-based ETFs track commodity futures contracts. Each type can be helpful depending on your investing goals, but because they are traded as securities, the same risks apply as with any other equity investment. Commodity ETFs provide significant diversification benefits to a portfolio and thus should be included in most passive investors’ portfolios.
When you invest in a commodity ETF, you are not investing in the commodities themselves. What you are investing in is the basket of contracts that make up your stocks, along with their fluctuations. These fluctuate based on future prices. While commodity ETFs ease investors’ market exposure since they can track a basket of commodities by investing in just one fund, they also have high levels of risk involved due to this high level of market exposure.
Commodities ETFs are very popular among traders who invest using technical analysis because it allows them to predict future movements by looking at charts and graphs, just like other funds. It includes commodity trading advisors (CTAs) whose total assets under management have risen from $465 million in 2000 to an estimated $5 billion as of 2010.