Five Things to Know About Commodity ETFs

February 12th at 6:00am by Tom Lydon

Commodity exchange traded funds have been a boon to individual investors because they give exposure to certain areas of the market that were once hard to reach. These ETFs are also one of the best ways an investor can diversify their portfolio.

Up until a few years ago, the average individual investor could not invest in gold or currencies with the ease of a simple transaction. With the advent of commodity focused ETFs, any investor can access any commodity with the ease of buying a single stock.  [iShares Launches Specialized Global Commodity Producers ETF]

After the stock market volatility that was seen in 2011, investors are more aware of the need for diversification across several asset classes and sectors than ever before. There are certain aspects about commodity ETFs that investors should consider before buying any such fund. [Natural Gas ETFs: Rebound, or Another Head Fake?]

  1. There is a difference between an ETF that invests in commodity stocks versus an ETF that invests in the actual commodity. For instance, the SPDR Energy  Select Sector Fund ETF (NYSEArca: XLE) is composed of a basket of stocks that are energy companies or do business with the energy sector. On the other hand, there is the United States Oil ETF (NYSEArca: USO) which moves in step with futures contracts that track the price of oil. Rather than investing in the physical commodity, the fund tracks the futures contracts.
  2. Diversification is one of the key benefits of commodity investing. Commodity ETFs such as the PowerShares Energy ETF (NYSEArca: DBE) is composed of five commodities: light crude, brent crude, heating oil, gasoline and natural gas. This type of ETF can give major exposure across the commodity board with one investment.
  3. Contango is a factor that comes into play when investing involves futures contracts. This is a problem that long term investors have to deal with more than short term traders. With contango, every following month’s futures contract is priced slightly higher than the previous month. This is because the futures market is saying oil is plentiful now — therefore the lower price — but not so plentiful in the future. [Silver Miner ETFs Keep Pace with Metal's Price Rise]
  4. Backwardation is the opposite of contango, and is another factor that pops up when investing with futures based contracts through an ETF. Backwardation occurs when prices decline in the future — that means the commodity is in short supply at present, but in the future abundance is expected. Futures contracts are useful for the producers and consumers of the commodity that want to lock in guaranteed delivery for specific dates, not for investors.
  5. Commodity ETFs are a good way for investors to hedge inflation. Historically, commodities prices have had low correlations to stocks and bonds. Commodity ETFs are affected by different risk factors than stocks, such as storage, capacity, supply and demand, delivery and weather. [Three Things to Know About Currency ETFs]

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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