Before exchange traded funds (ETFs) covered the commodities space, a person had to either be part of a large institution or have an account in the commodities pits to gain exposure to price movements in the commodities market. Now, any average retail investor may trade in commodities with a click of a mouse.

Commodity ETFs provide exposure to the broader categories, such as agriculture, metals, and energy, along with the many different single commodities found within the main categories. Most commodity-based ETFs gain exposure to their underlying commodities through three primary formats: physical, futures and equities.

Broad Commodity ETFs

To start off, broad commodity ETFs hold a basket of commodities and offer investors the opportunity to diversify into the commodities market. The main commodity indexes that these ETFs track include the Goldman Sachs Commodities Index (GSCI) and the Dow Jones-USB Commodity Index (DJ-USBCI). Commodity ETFs can also be broken down to other sub-classes like agriculture, metals and energy.

However, the major drawback of broad commodity ETFs is that each commodity are lumped into one broad asset class, which would ignore the various fundamentals that affect the price movements of individual commodities.

Physically-Backed ETFs

Currently, only precious metals ETFs are backed by the physical commodity because it is much easier to gather and store the precious metals bullion in a vault, as compared to other commodity assets. Each share of a physically-backed ETF traded on an exchange represents a partial ownership of the precious metal bullion owned by the fund. The metal bars are safely secured in vaults in London or Zurich, depending on the precious metal ETF. Investing in physical commodity ETFs offers the exposure to the underlying commodity without the hassle and added costs of monitoring and storing the precious metals yourself.

It should be noted that if a physically-backed ETF is held for more than a year, the ETF is taxed as a collectible. If the fund held under a year, it is taxed as capital gains. Potential investors should still consult their tax experts. [Commodity ETFs: Physical vs. Futures.]

Futures-Based ETFs

A majority of commodity ETFs deal with futures contracts traded on the commodities exchange. The futures contracts are usually settled or swapped for cash before the date of maturity to prevent the fund from taking actual physical delivery.

However, by settling contracts in cash, futures-based ETFs will come with a time component that could affect the ETF. For instance, when the front month contracts cost more than today’s contracts, the futures contract is in contango, the opposite is called backwardation. If the underlying commodity’s futures contracts are in contango, the ETF could lose money when the managers roll contracts. [Commodity ETFs: Understanding Contango.]

Some futures-based ETFs, though, utilize strategies that try to mitigate the effects of contango by holding positions in markets under backwardation. For example, “optimum yield” futures-based indexes try to include contracts that mature in the month with the highest “implied roll yield” to minimize the effects of contango and maximize the effects of backwardation as a way to generate optimal returns.

It should be noted that futures-based ETFs are taxed as partnerships – the costs of the fund are spread among all of the owners at the end of the tax year, regardless of the time it was bought or sold through the year.

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