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.