What is an ETF? — Part 22: Commodities

August 20th at 12:45pm by Tom Lydon

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 21: Preferred Stocks]

Before ETFs, trading in commodities was limited to investors with the time and money to carefully navigate a commodities broker account. Now, ETFs have democratized the way we trade commodities, providing the average retail investor the opportunity to gain exposure to various natural resources.

Commodities are negatively correlated with traditional stocks and bonds, serving as a portfolio diversifier – a negative correlation implies that there is a low relationship between the commodities and that of traditional assets. By allocating a small proportion of your wealth into commodities, you may be able to reduce overall portfolio volatility – if stocks and bonds underperform, commodities would help buoy the overall portfolio.

Some commodity ETFs may also provide equity-like returns, generating robust performances during economic booms when countries require basic materials to fuel growth. Unlike traditional financial assets, commodities are tied to macroeconomic conditions.

Moreover, commodities are also used as a hedge against inflation. By taking on exposure to commodities before inflation manifests, or in its earlier stages, an investor may retain purchasing power as prices rise up and the U.S. dollar depreciates.

To get the true diversification value of commodities, investors may consider futures-based or physically-backed commodity ETFs. Physically-backed ETFs eliminate the need to find storage and futures-based ETFs may make the ordinarily expensive and complicated world of futures investing more wallet-friendly and easier to follow.

Most commodity ETFs get their exposure to commodities via futures contracts. A future is a promise to buy or sell a commodity for a set price at a set date in the future, and most are settled or swapped for cash before the expiry date to avoid taking physical delivery of the actual commodity.

Futures also add a time component to the price. When tomorrow’s cost is higher than today’s spot price, it is called contango, and the inverse is called backwardation. When contango is in play, futures-based commodity ETFs can lose money when they roll their contracts.

An increasing number of commodity ETFs are also backed by the actual commodity itself, though this space is mostly populated with precious metals ETFs. For instance, the SPDR Gold Shares (NYSArca: GLD) is the second largest U.S.-listed ETF, with $65.6 billion in assets. Each share of a physically-backed ETF represents a fractional ownership of metal bars owned by the fund, which are stored in secure vaults around the world.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

Full disclosure: Tom Lydon’s clients own GLD.

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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