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It's no surprise that commodities as an asset class have exploded recently, given the rising demand for food and raw materials in emerging markets like China and India. Starting with gold, many individual commodities have reached or are heading for record prices, and show no signs of slowing down or reversing direction.
Indeed, commodities exchange-traded products are one of the fastest-growing "alternative" sectors of the exchange-traded marketplace, swelling from $36.2 billion to $73.7 billion in total assets in 2009. The scope of commodities products is vast, and grows larger every day. From bullion-based gold trusts to index funds tracking grain futures, there's opportunity here for any investor.
Physical Funds
Structurally, physically backed funds are probably the simplest: These funds hold a given commodity in a vault and issue shares based on the price of that supply, minus management fees (which are paid for by liquidating some of the supply every year). The wildly popular SPDR Gold Trust (NYSEArca: GLD) follows this model.
Naturally, however, this structure is mostly limited to precious metals, which can't rot or decompose, and which investors already commonly hold for long time periods. Nobody would want a physically backed corn ETF, for example, as the kernels would be better off being sold and eaten than socked away in a vault.
Futures-Based Funds
Many more ETPs are futures-based, meaning they track a basket or index of one or more commodities futures contracts, buying up (or "rolling over") to another contract whenever the current one expires. These funds typically put up a fraction of their total assets to purchase the relevant contracts; the rest is usually invested in Treasurys to build interest income.
Some products track a single commodity, like the U.S. Oil Fund ETF (NYSEArca: USO), while others track an index of several commodities, like the PowerShares DB Agriculture Fund (NYSEArca: DBA) or the GreenHaven Continuous Commodity Index ETF (NYSEArca: GCC).
Futures-based ETFs do offer pure-play exposure to the financial commodities markets, but investors should understand that futures-based commodity ETFs will not track closely to spot prices. The reason is that prices of futures contracts may be either more or less expensive than spot prices. Similarly, the price of futures contracts that expire at different times may different as well.
For instance, let’s imagine that spot oil is trading at $80/barrel, but the current oil futures contract---due to expire in three weeks---is priced at $82/barrel. If spot stays at $80/barrel, the value of that futures contract will move from $82/barrel to $80/barrel over the next three weeks. After all, futures contracts are designed to expire priced at spot.
If an ETF buys the $82/barrel futures contract and holds it until expiration, it will lose $2/barrel over that time period.
In practice, ETFs don’t hold futures until expiration. They sell them before expiration so that they do not have to take physical delivery of the oil. They then buy futures contracts dated further out the curve. In our example above, an ETF might sell its futures contract the day before expiration for $80.10/barrel, and then buy another contract dated out four weeks. Chances are, that contract is priced higher than spot as well: perhaps at $83/barrel.
The process repeats.
When futures markets are shaped like this, with out-month contracts priced higher than near-term contracts, the markets are said to be in contango. All else being equal, this hurts returns.
Of course, the reverse situation can also be true: out-month contracts can be cheaper than near-term contracts or spot. In that case, the markets are said to be in backwardation. All else being equal, this helps returns.
Issuers have tried to circumvent contango and amplify backwardation by launching funds with diverse baskets of futures that span several months, or by selectively choose the “best” contract to purchase from a range of contract months. These approaches can help, but they cannot mitigate the impact of contango altogether.
Commodity ETNs
Futures-based exchange-traded notes deserve a mention as well, considering they theoretically should offer better performance than futures-based ETFs. ETNs, which are unstructured debt instruments, hold no contracts or securities. They're simply a promise from a credit issuer to match a certain index's performance. Thus, they can perfectly replicate their benchmarks, without incurring any pesky transaction costs, minus fees.
They do, however, carry the credit risk of the underwriting bank, and in a post-Lehman Brothers market, many investors remain wary of this structure.
ETNs remain a tiny but important share of the commodity ETP universe, as they offer pure-play exposure to certain commodities (like coffee or cocoa) that can't be accessed in any other exchange-traded way.
Equity ETFs
Equity-based commodities ETFs avoid the issue of contango and issuer credit risk altogether, as they hold indexes or baskets of commodity companies, such as drillers, explorers, growers and refiners.
Some stock-based ETFs focus on a single sector, like gold miners (the Market Vectors Gold Miners Index ETF (NYSEArca: GDX)) or steel companies (the Market Vectors Steel Index ETF (NYSEArca: SLX)), while others take a broader approach across several sectors, like the iShares S&P North American Natural Resources Fund (NYSEArca: IGE).
Stock-based ETFs offer different risk/return profiles than futures-based ones, and they tend to correlate more closely with general U.S. equities than with the commodity spot markets. Still, equity funds can help investors find corporate upside and leverage in the commodities markets.
Taxes
As noted previously, different commodity ETFs have different tax treatments. Precious metals bullion funds are taxed as collectibles, meaning they are subject to 28 percent taxes on capital gains. Futures-based funds are taxed as futures, meaning all gains are “marked-to-market” at year-end and treated as 60 percent long-term and 40 percent short-term gains. And equity funds are taxed like equities.
When in doubt, find out.
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