Commodity exchange traded funds (ETFs) have become one of the most popular fund types with investors. They don’t all work the same, however, and before you dive in, you need to understand this market in a bit of detail to avoid getting surprised, or worse, burned.

Michael Iachini for Charles Schwab reports that in order to understand how commodity ETFs work, you’ll need to know what it’s tracking and how it’s tracking it.

  • Spot Price: The spot price of a commodity is the price that it is trading at right now. If you wanted to buy a barrel of oil or a bushel of corn to take home today, you would pay the spot price.
  • Futures Price: The futures price is the price you would pay today for the right to receive the commodity at some point in the future (for example, three months from today). With a futures contract, you’re locking in a price today rather than waiting to see what the spot price will be at some point in the future and then making the purchase at that price. It’s most advantageous, of course, to see the futures price go up after you’ve locked in a lower price.

But if the futures price does go up, it means the market for that commodity is in contango. An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango, because the fund manager has to go in and buy a more expensive futures contract.

As ETF providers become more aware of these issues, however, they’re structuring their strategies around mitigating the impact of contango. Backwardation is the opposite phenomenon, Joyce Hanson for Advisor One reports.

There are two key types of commodity ETFs that give exposure to prices:

  • Physical ETFs: If your ETF holds the physical commodity, the value of your ETF shares will move with the spot price of the commodity, though the price could also be affected by security issues and the cost of storing the commodity itself. ETFS Physical Swiss Gold (NYSEArca: SGOL) is one of the growing number of such funds; each share is backed by a fractional ownership in gold bars, which are stored in secure vaults around the world.
  • Futures Contracts: Other ETFs hold baskets of futures contracts and never take possession of the physical commodity. This is the most common commodity ETF structure, whether it’s for oil, agricultural commodities, broad baskets of commodities or even some precious metal ETFs. Storing oil or wheat is more difficult than storing bullion, which is why these ETFs don’t just hold the physical goods. United States Oil (NYSEArca: USO), which owns oil futures contracts, is one example of such a fund. In fact, most commodity ETFs own futures – they’re less frequently physically-backed. [Commodity ETFs: Coping With A Possible Bubble.]

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.