Making Sense of Commodity Exchange-Traded Products

By Grant Engelbart, CFA

For hundreds of years, investors have been buying and selling commodities. In fact, sources point to the first commodity futures contract dating back to the 1600s! Given this lengthy history of investing, it is quite surprising that investing in commodities was very difficult for the retail investor until exchange-traded products (ETPs) made things easier. In 2004, the first commodity ETP was launched as a way for investors to hold gold. Today there are over 100 U.S.-listed commodity ETPs, used by investors of all types; however, how these products work is often misunderstood.

Funds

Traditional commodity exchange-traded funds (ETFs) either hold physical commodities or commodity futures contracts. Physical commodity ETFs generally only exist for products that make sense to store over long periods of time, such as precious metals. For instance, gold is held in a vault backing each share of the corresponding ETF that exists. The price of the ETF reflects the change in the spot price of gold throughout the day. Now you can’t ask for the physical gold that backs your shares, but if there is enough interest (or lack thereof) in the product to cause an imbalance between the price of the ETF and how much gold is in the vault, the trustee may have to go and purchase (or sell) more physical gold. Pretty interesting, don’t you think?

Futures-based commodity ETFs are generally used for broad-based commodity indexes and other commodities that don’t make sense to physically hold (corn does poorly in vaults). The price of these ETFs reflects the price of the commodity futures, not the spot price. This can result in large return differences between the spot price of a commodity you see on television versus the actual return of the ETF. Commodity ETFs arranged as partnerships will generally issue K-1 tax forms, which can be a pain. However, some new structures in the ETF world have made the K-1 nonexistent.

Notes

Exchange-traded notes (ETNs) trade much like traditional ETFs; however, they aren’t funds at all. An ETN is actually debt issued generally by a bank. This debt has a maturity date on which the bank promises (key word) to pay the return on a specified index, such as the spot price of oil, at maturity. Investors can redeem their notes with their issuers for the current price, which keeps the ETN trading very close to its stated benchmark. In fact, many ETNs have lower tracking errors than ETFs because they don’t have to deal with purchasing futures as mentioned above. Since these notes are debt issued by a bank, which is generally unsecured, the credit quality of the issuer is important when purchasing ETNs. ETNs will also avoid the aforementioned K-1 tax form, as they are not arranged as partnerships.

Inclusion in a Portfolio

Commodities have been one of the most hated asset classes over the past year. For the contrarian, this creates opportunity. Commodities are generally a more volatile asset class. However, in combination with a traditional balanced portfolio, commodities can increase risk-adjusted returns over the long term and also help protect against inflation.

When thinking about including commodities in a portfolio, there are many considerations. Historically, energy commodities have correlated the most with the broad equity market; while agricultural commodities tend to be more defensive (have better returns when the stock market is down). From a risk and return standpoint, a longer-term allocation to commodities through an index that has some weight in agriculture makes sense. For those more tactical in nature, during recoveries after commodity bear markets (such as the one we are in), energy-related commodities have outperformed on the way back up.

Commodities are of course cyclical in nature, but they can provide the needed “zig” when the rest of your portfolio is “zagging”. Exchange-traded products provide for easy and sometimes efficient access to commodities. Make sure you pay attention to the way the index is put together, as many can differ significantly. Tax consequences for your clients are also very important. With some research and a little due diligence, it won’t be long before commodities are working again for your clients.