Types of Commodity ETFs You Must Know About
Commodity exchange-traded funds let investors expose themselves to individual commodities or baskets of commodities in a simple, low risk, and cost-effective way. There are various commodity ETFs that invest in different commodities. The following are the types of commodity ETFs you should definitely know about.
Commodity ETFs based on equities hold stock in businesses that produce, store, and transport commodities.
This type of ETF can provide investors some exposure to multiple companies or particular sectors. It’s different from investing directly in stocks because it’s simpler and cheaper.
Also, the risks related to physical and futures commodity ETFs aren’t present in this type of fund. The expense ratios for the funds are also usually lower.
The only downside to this is that you also have to consider the company structure, since you’re going to deal with stocks.
Exchange-Traded Notes (ETNs)
Another type of a commodity ETF is an exchange-traded note. An ETN is a debt instrument that comes a bank.
It is a senior, unsecured debt that has a maturity date. The issuer backs it. This asset tries to match the returns of an underlying asset using different strategies, such as buying stocks, options, or bonds.
The advantages of ETNs include the absence of tracking error between the ETN and the asset it is tracking. ETNs also receive better tax treatment. As an investor, you only have to pay regular capital gains when it is sold.
But when you choose ETNs, you have to consider carefully the credit quality of the institution that issues it.
Physical funds or physically backed funds hold actual commodities in the fund. However, as of now, they are only exclusive to precious metals.
The advantage of a physical ETF is that it actually owns and has the commodity in possession. As a result, there is no tracking and counterparty risk.
Tracking risk takes place when the ETF doesn’t offer the same returns as the asset it is supposed to track. Meanwhile, the counterparty risk is the risk that the seller does not actually deliver the commodity as promised.
The downside to physically backed funds is that you have to shoulder various costs that have something to do with delivering, holding, and insuring physical commodities.
Now, futures funds are the most popular type of commodity ETFs. These are exchange-traded funds that are futures based, and they build a portfolio of futures, forwards, and swaps contracts on the underlying commodity.
Futures-based funds don’t require you to pay the costs of holding and storing the underlying commodity. However, you should also consider other risks that have something to do with the futures contracts themselves.
Most of these funds follow a “front-month” roll technique in which they hold front-month futures, or the futures that are closest to expiring.
The ETF has to replace those futures before they expire. They replace them with the second month futures.
One of the most appealing features of this fund is that it closely tracks the current or spot price of the commodity. Meanwhile, there is the “rolling risk” as the expiring front month contracts are rolled into the second month contracts.