Exchange traded funds allow investors to diversify a traditional stock and bond portfolio with commodities. However, the commodities asset class comes with its own risks.
“As with everything, investors should be aware of what they are actually buying when they go shopping for a commodity-focused exchange-traded product,” writes John Gabriel, a strategist for Morningstar‘s manager research team. “A look behind these funds’ labels will show that they are often not what they seem.”
For starters, most commodity ETFs do not track the spot price, or commodity prices as investors see them in the headlines. However, there are some exceptions, including precious metals-related exchange traded products that are backed by physical gold, silver, platinum and palladium bars stored in bank vaults.
Most commodity ETFs track futures contracts. The futures market may diverge from the spot price due to a number of factors, including storage costs and seasonal patterns, among others. Consequently, investors would be exposed to the intricacies of the futures market, which may not perfectly reflect the spot price returns of the underlying commodity.
Specifically, investors will have to be wary of roll returns or roll yields. Since the commodity ETFs hold futures contracts, these ETFs avoid physical delivery before a contract expires by rolling the contract or buying a new contract with a later maturity date.
“Roll yield will lead the returns of commodity futures indexes and funds to diverge from commodities’ spot price performance,” Gabriel said.
Futures-backed commodity ETFs will expose investors to contango and backwardation in the futures market. If the futures market is in contango, a commodities contract that is set to expire will cost less than later dated contracts. If the futures market is in backwardation, the contract that is set to expire costs more than later-dated contracts. Consequently, it would be in the best interest of a futures-based ETF investor to limit the negative effects of contango and profit off backwardation as the ETFs roll contracts set to expire for a later-dated contract.
To limit the negative effects of contango, Gabriel suggests investing in futures-backed commodity ETFs with longer-dated contracts.