WHAT YOU NEED TO KNOW ABOUT
COMMODITY ETFs

Thinking about investing in commodity ETFs? Learn about what they are, how they work and what you should know before adding them to your investment portfolio.

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An introduction to commodity ETFs

Commodity ETFs allow you to get exposure to various selected commodities, such as gold and oil, without having to engage in more complex investment strategies such as trading CFDs. In addition, you also don’t have to purchase and store the physical asset.

In this guide, you’ll gain insight into what commodity ETFs are, how they work and the level of due diligence you should conduct before investing in them.

What are commodity ETFs?

Commodity exchange-traded funds (ETFs) are a type of ETF that invests in a variety of different physical commodities. These physical commodities may include precious metals, agricultural products, resources, such as crude oil, and more. The way a commodity ETF is set up means you don’t have to trade a CFD or purchase the physical goods directly. This makes it easier to diversify your portfolio into precious metals or other valuable resources.

While they may not be the first preference for beginner investors, experienced traders understand the value commodity ETFs provide as a hedge against inflation. Whilst there are no hard and fast rules commodity prices can at times be inversely correlated to the prices of other asset classes such as stocks and bonds. In simpler terms, when stocks and bonds lose value, the value of commodities generally increases — and vice versa. 

So, if investors see inflation as having a negative effect on their portfolio of stocks and bonds, they may choose to diversify into commodities — or commodity ETFs — to balance the impact.

There are four different types of commodity ETFs you may wish to invest in:

• Physically backed funds
• Equity funds
• CFDs
• Exchange-traded notes (ETNs)

Each type has its own pros and cons, so make sure you understand the intricacies of the commodity ETF you want to invest in before you spend your hard-earned money.

How do commodity ETFs work?

Investing in commodities such as gold by buying the asset in its physical form can be inconvenient and expensive. This is especially true in large quantities, such as a tonne of coffee beans, as it’s only in high quantities that many investors feel they’re getting enough exposure to the commodity.

Commodity ETFs bridge this gap by allowing investors to get exposure to commodity markets without having to factor in storage and insurance costs. This is because many commodity ETFs don’t invest in the physical commodity itself, but rather invest in cash and enter swap contracts to get exposure to the commodity’s performance of CFDs.

These commodity funds typically track the price performance of indices based on the futures contracts. This is why they are often referred to as “synthetic” funds. This is not the case with all commodity ETFs, as some are structured based on being 100% backed by cash, while others physically hold the asset — such as holding physical gold bullion bars in a bank vault.

Here are some of the most common commodities that traders can invest in via a commodity ETF:

• Crude oil
• Wheat
• Golder, silver and copper
• Coffee beans

As mentioned earlier, there are four different types of commodity ETFs, and each requires careful consideration before you start investing. This is because the way they’re structured differs, and some may have a much higher risk factor than others.

1. Physically backed funds

While generally rarer than synthetic commodity ETFs, physically backed funds actually hold the underlying commodity. So, for a gold ETF, for example, the fund may allow investors to gain ownership of their stockpile of gold bullion — without having to acquire and store that valuable asset themselves. 

Be aware, however, that physical precious metal ETFs are taxed as collectibles, which may make short-term trades less attractive compared to investors who are using these funds to diversify their portfolios over the long term.

2. Equity funds

There are also funds comprised of the companies that actually produce, move and store the underlying commodity. This gives you equity-based commodity exposure, and it may be the most viable alternative to futures-backed ETFs for more risk-averse investors. This type of commodity ETF also tends to have more palatable tax implications than physically backed funds.

3. Contract for Differences (CFDs)

CFD trading is a method of trading in which an individual engages in a contract with a CFD broker, rather than purchasing the underlying asset directly. CFD trading offers the opportunity to apply leverage, and/or go long or short. It is important to note that leverage increases market exposure, and, therefore, increases risk.

4. Exchange-traded notes (ETNs)

The final way you can get exposure to commodities through ETFs is via exchange-traded notes. ETNs are senior, unsubordinated and unsecured debts that are linked to both commodities and currencies. As these are debt instruments issued by banks, they have a maturity date and are backed by the institution that issues them. 

They may deploy a variety of strategies to match the returns of the underlying commodity, such as by purchasing stocks, bonds or options. ETNs have favourable tax treatments compared to other types of commodity ETFs because you only pay regular capital gains tax when they are sold.

What are the advantages and disadvantages of commodities?

For many, the biggest advantage of investing in commodities is the diversification they provide, particularly in terms of how the market movements of commodities are generally unrelated to what is happening with stocks and bonds.

Commodity ETFs are not without their drawbacks, however. Depending on the type of fund you choose, it can come saddled with significant volatility.  Because the value of the underlying commodity is based on supply and demand, external factors such as macroeconomic trends, and environmental and geopolitical events can have a big impact on the supply of certain commodities.

One final disadvantage is the way commodity ETFs are treated for tax. Not only are they complex to understand, but you could potentially end up paying more tax than just capital gains if the ETFs are treated as holding collectibles.

Should you invest in commodity ETFs?

If you want access to commodities without the significant outlay of acquiring and holding the physical assets yourself, commodity ETFs may be suitable for your portfolio. They can also be used as a hedge against inflation, and may be more limited in exposure and risk compared to other ways of investing in commodities. However, they may not be for everyone.

Because many commodity funds create their own benchmark index that includes the underlying commodity (e.g., natural resources or precious metals), there may be a tracking error around broader commodity indices — such as the Dow Jones Commodity Index.

In all things, due diligence is critical and you should do sufficient research so that you understand how the commodity ETF is run, what type of fund it is, what the underlying index methodology is, and whether it aligns with your investment goals and risk tolerance.

Which commodity ETFs can you invest in on eToro?

Once you have familiarised yourself with how commodity ETFs work, it is time to explore some of the most intriguing funds currently available in the market. The good news is that you can invest in commodity ETFs on eToro in just a few simple steps. Here are some funds to consider:

• UGA: The United States Gasoline Fund LP tracks the daily changes in gasoline prices. The fund was launched in 2008, uses US dollars as base currency and mainly invests in RBOB contracts in the United States.
• SLV: The iShares Silver Trust seeks to track the overall performance of the price of silver on the US stock market. The fund gives exposure to the day-to-day movement of the silver bullion price in America and is based predominantly in the United States.
• XOP: The SPDR S&P Oil & Gas Exploration & Production ETF seeks to provide investment results that track the total investment return of the S&P Oil & Gas Exploration & Production Select Industry Index, an index designed to track the oil and gas segment of the S&P Total Market Index.
• BAR: The GraniteShares Gold Trust is an independent and fully funded exchange-traded fund company, and one of the lowest-cost gold ETFs available.
• DBO: The PowerShares DB Oil Fund seeks to track the DBIQ Optimum Yield Crude Oil Index.
• DUST: The Direxion Daily Gold Miners Index Bear 2X Shares seeks daily investment returns of -2x the performance of the NYSE Arca Gold Miners Index.
• DRIP: The Direxion Daily S&P Oil & Gas Exp. & Prod. Bear 2X Shares seeks daily investment results of -2x the performance of the S&P Oil & Gas Exploration & Production Select Industry Index.

While not necessarily for every type of investor, commodity ETFs offer a change of pace from stocks and bonds and can be incorporated into your portfolio to help with diversification and to hedge against the effects of inflation. But not all commodity ETFs are created equal, so make sure you research the funds and ensure they align with your overall investment strategy before diving in.

Visit the eToro Academy to learn more about how commodity markets work

FAQs

Do commodity ETFs pay dividends?

That depends on the commodity ETF you decide to invest in. Like any type of ETF, some funds will pay out dividends to shareholders, while others will choose not to. It is important to do your research and find out whether your chosen commodity ETF pays out dividends regularly.

Are commodity ETFs a good investment?

There’s no defined ‘good’ or ‘bad’ investment type. It depends on your risk appetite, how you want to diversify your portfolio, and whether or not you believe in the future profitability of your chosen commodity ETF. All these factors should be considered before you invest.

What is the best commodities ETF?

Past performance is never an indicator of future success, however, it may help you to understand which commodity ETFs are currently performing well. This may allow you to get in at the right time. However, if a commodity ETF’s value has fallen recently, it may also be a more cost-effective time to get into the market. Always do your due diligence before investing in commodity ETFs.