One of the biggest problems commodity investors face is finding a way to invest without having to trade in the futures market. Commodity-based stocks can partially do the job, but there really aren’t many “pure play” stocks. If you like gold, silver or any other precious metal, investing in a mining company can be a good idea, but it still doesn’t pass for the underlying commodity itself.
Companies trade based on fundamentals and other market forces. While the price of a commodity will certainly be a factor in determining the stock’s value, things like earnings, mining reserves, land rights, debt and a slew of other details are also part of what makes up a company’s total value.
Luckily for investors, the advent of the commodity-based ETFs helped pave the way for a “purer play” on commodities. Unlike commodity-base stocks, these ETFs either invest directly in the commodity they represent or in commodity futures. They have a much lower correlation with stocks and tend to move in step with the commodity they represent.
But many investors make the mistake of assuming an ETF that tracks a commodity is simply a replacement for the commodity itself. It’s a false assumption fraught with risks of which an everyday investor may not even be aware.
Marking the Differences Between ETFs and Commodities
The quickest way to find out if a commodity-based ETF and a commodity trade alike is to simply compare performance over time. Let’s examine the relationship, from September 2015 to 2016, between one of the most popular commodities to trade and the largest ETF in the space: oil and the ETF US Oil Fund (USO).
Right off the bat, we can see there is a distinct difference in value between oil and the ETF designed to track it. The US Oil Fund doesn’t actually hold oil – instead, it holds a basket of futures contracts that mimic oil’s performance. Add in management fees, transaction costs and contango, and it becomes a little more obvious why the ETF’s performance generally trails below oil. The same price disparity exists between Natural Gas Futures and the ETF US Natural Gas Fund (UNG).
But this doesn’t hold true for all ETFs and commodities. Take a look at the comparison between gold and the SPDR ETF Gold Shares (GLD):
The reason these two track more closely is because the SPDR Gold ETF (GLD) holds actual gold in its portfolio. Storage costs are reflected in the performance, but also show up in the performance of gold futures – making the price disparity far less than that of ETFs who hold a mix of futures contracts instead.
The Problem of Time Decay
The enemy of commodity futures and commodity-based ETFs is contango. Contango is where near-month futures prices are cheaper than those that expire further out. This creates an upward curving slope in prices, which contributes to a negative roll yield. The primary cause of this effect is due to costs – such as storage costs for the physical commodity – outpacing benefits, like convenience yield.
While contango can be avoided by holding off purchasing a commodity until the price disparity is gone or purchasing a contract further out, ETF investors don’t have that option. Commodity-based ETFs that hold a basket of futures contracts are designed in one of two ways: front-month or full-year.
In front-month ETFs, futures contracts are purchased in the front-month and then rolled over when the expiration date comes up. But a monthly rollover exposes investors to a high degree of contango when there is an upwards curving slope in prices. Full-year ETFs are slowly replacing front-month ones, and diversify against this risk by purchasing contracts with varying expiration dates, thus, cutting down on the risk of contango – but not eliminating it entirely.
Using ETFs as a way of investing in commodities is still a valid strategy, but investors need to be aware of how the ETF is structured. Those that own the physical commodity will be subject to less price disparity and less contango than those that own a basket of futures contracts.
Ultimately, ETFs that hold futures contracts are best used for short-term investors looking for a quick turnaround, while long-term investors will want ETFs that hold the physical commodity, since they can absorb the negative impact of contango much better.