Commodity ETFs give individual investors an easy way to diversify
- Commodity exchange-traded funds (ETFs) are funds that invest in raw materials.
- These funds help investors gain quick access to the commodity markets.
- Investors can buy and sell commodity ETFs the same way they do stocks.
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Commodity investing is appealing for several reasons. It’s a great way to hedge against inflation, generate compelling returns, and diversify a portfolio.
But for individual investors, it’s usually not practical to buy physical raw materials like gold, copper, and oil or futures contracts tied to them. Those markets are largely the realm of professionals, given the high costs and complexity involved.
That’s where commodity exchange-traded funds (ETFs) come in.
What are commodity ETFs
Commodity ETFs are securities (financial instruments that investors can trade) that provide exposure to the price changes of raw materials. These funds trade like stocks, so investors can buy and sell them on exchanges throughout the day.
Further, investors can short sell shares of ETFs, meaning they can borrow shares from a lender and then sell them in hopes of purchasing them back later at a lower price. Investors can also buy ETFs on margin, which involves borrowing funds and then using them to purchase these securities.
Types of commodity ETFs
There are four main types of commodity ETFs:
- Physically backed ETFs: These funds hold the actual raw materials themselves, for example gold, silver or platinum.
- Futures-based funds: These use derivatives contracts, including futures, swaps and forwards, to grant exposure to different commodities. Regardless of whether the underlying raw-material price rises or falls, these ETFs can generate returns. These funds can potentially influence futures prices, instead of simply following them, because they make so many transactions.
- Equity-based commodity ETFs: These funds provide exposure to the stocks of companies involved with natural resources or other raw materials. For example, businesses that take part in extracting, producing, storing, or shipping these commodities.
- Exchange-traded notes (ETNs): These are debt-based securities issued by financial institutions. They track an underlying index, similar to many ETFs. ETNs don’t pay dividends, instead of providing lump-sum payments, which can help investors who own them to avoid short-term capital gains taxes.
How do commodity ETFs fit in an investment portfolio?
Commodities are alternative investments, meaning they are alternatives to more traditional assets like stocks and bonds. Investors can incorporate commodity ETFs into their portfolios in order to improve diversification.
There is strong statistical data supporting the ability that commodities have to diversify investor portfolios. Between 1970 and 2017, the annual returns produced by the Bloomberg Commodity Index and the S&P 500 had a correlation of 0.3, which is rather low, according to the investment management firm Pimco.
Quick tip: Commodities have a track record of displaying a low correlation to stocks and bonds, making them a valuable tool for diversification.
The aforementioned commodity index had the same correlation with the Bloomberg Barclays Global Aggregate Index, a measure of global bonds.
Investors can also harness commodity ETFs to hedge against inflation, as raw materials have frequently experienced predictable gains when unexpected inflation materialized. In other words, when key inflation measures, like the consumer price index, went up, commodity prices often rose along with them.
“Commodity ETFs can be attractive because they can be uncorrelated with other asset classes (like the stock and bond market in general) and also provide a hedge against inflation,” says Lana Khabarova, founder of SustainFi, a platform for impact investing. For instance, an agriculture ETF could be a good investment if food prices are on the rise.
At the same time, Khabarova cautions that commodities have been more volatile than stocks, so investors should limit the portion of their funds invested in them. “They are there for diversification but are not meant to be a core investment,” she adds.
Christopher G. Huemmer, senior investment strategist for FlexShares ETFs at Northern Trust Asset Management, says commodities should be one part of a mix of asset classes investors use to hedge against rising inflation. He suggests that they harness Treasury Inflation Protected Securities (TIPS) in the short-term, natural resources and commodities in the intermediate-term, and real estate and global infrastructure over the long-term.
“Over that intermediate time horizon, both commodities and natural resource equities have done an excellent job historically of battling inflation and giving investors an alternative source of returns beyond stocks and fixed-income securities,” Huemmer says.
What are the pros and cons of commodity ETFs?
One major benefit of commodity ETFs is that they can provide an investor’s portfolio with greater diversification since raw materials have frequently displayed little correlation to stocks and bonds.
Another major draw of these funds is that they can help investors hedge against inflation since natural resources and raw materials have frequently increased in value when consumer prices are pushed higher.
Further, commodity ETFs provide investors with a way of obtaining returns that don’t move in tandem with those of stocks.
As for drawbacks, commodity ETFs can experience significant volatility . Their prices are a function of supply and demand. Bad weather, for example, can have a substantial impact on the supply of certain agricultural commodities.
In addition, the tax treatment of commodity ETFs can be complex. If you invest in funds that hold precious metals directly, you might end up paying taxes higher than your long-term capital gains tax rate or even your income tax rate, since the current tax rules treat these ETFs as collectibles.
Further, commodity ETFs that make use of futures can potentially affect the price of these derivatives contracts by executing a large number of transactions. This situation creates additional uncertainty for these funds.
How do you buy commodity ETFs?
You can use a brokerage or retirement account to purchase shares of commodity ETFs. If you don’t currently have one, you can establish one of these accounts by going through either a financial institution or your employer.
Quick tip: Any investor with a brokerage or retirement account can buy commodity ETFs.
Once you have set up one of these accounts, be sure to conduct the appropriate research on commodity ETFs that interest you so you can find one or more that are a fit for your objectives, risk profile and time horizon. If you think it will prove helpful in evaluating these matters, consider seeking the assistance of a financial professional. When you have selected a fund that is a good fit, you can buy it just like you would purchase shares of stock.
When considering commodity ETFs, investors should keep in mind the many potential benefits they provide. For example, their strong ability to provide diversification or hedge against inflation. Further, they should remember that these funds provide quick, efficient exposure to these raw materials.
However, investors should also keep in mind that commodity ETFs have their drawbacks. For example, sharp volatility and complicated tax rules.