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.
“Investing in longer-dated futures contracts can do a bit to mute the effects of regular rolling, which are typically most pronounced in front-month futures,” Gabriel added. “However, this strategy isn’t foolproof, and real results are mixed at best.”
For instance, the PowerShares DB Oil Fund (NYSEArca: DBO) and United States 12 Month Oil Fund (NYSEArca: USL) provide exposure to WTI oil but include a different weighting methodology to limit the negative effects of contango. DBO can include contracts as far out as 13 months and dump contracts at any point. USL, on the other hand, ladders 12 months of contracts to diminish the effects of backwardation and contango.
In contrast, the U.S. Oil Fund (NYSEArca: USO) tracks near month crude oil futures, swapping out contracts within two weeks of expiration for the next month contract. Consequently, in a contangoed market, USO would essentially be selling low and buying high, which may cut into performance. [Widening Contango Could Cut Into Popular Oil ETF’s Returns]
For broader exposure, the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC) and United States Commodity Index Fund (NYSEArca: USCI) eschew rolling front month contracts, which can lead to underperformance, especially in a contangoed market. Instead, DBC targets futures contracts that offer the highest implied roll yield while USCI rebalances each month and selects the most-backwardated contracts and then the seven highest-returning contracts.
Due to the way these futures-backed ETFs are structured, ETF investors may have to fill out the complex K-1 form. However, the PowerShares DB Optimum Yield Diversified Commodity Strategy Portfolio (NasdaqGM: PDBC) also tries to maximize potential roll yield returns but is structured as a 1940s Act Registered Investment Company, so investors would only have to fill out a form 1099. [An Active Commodity ETF That Optimizes Returns]
For more information on the commodities market, visit our commodity ETFs category.
Max Chen contributed to this article.