Earlier this week, we at CommodityHQ.com attended the Global Grains North America conference in Chicago. There were a number of excellent and informative speakers and presentations, but as we took the stage to discuss grains ETFs (and commodity ETFs in general), we came upon a startling realization: there are still a number of investors completely unfamiliar with commodities in the ETF wrapper.
Only a handful of the attendees were familiar with ETFs at all, let alone those that focus on commodities. This brings us to an important discussion on commodity ETFs and how to make them work for you and your portfolio.
The 3 Kinds of Commodity ETFs
Currently in the commodity world there are three main types of ETFs available: first generation, next generation (sometimes referred to as second/third generation), and physically-backed products.
These are ETFs that are backed by the physical commodities. For now, this only applies to the precious metals space, as all four have their own physically-backed products (as well as a few that invest in baskets of physical metals). These are by far the most popular commodity ETFs on the Street, accounting for the lion’s share in AUM. But the distinction that we want to focus on is that of first-generation and next-generation commodity ETFs.
First-generation funds refers to the early days of commodity investing, when almost every new ETF invested in front-month futures contracts. Funds like UNG and USO fall under this category and still remain among the most popular products in the commodity space. The biggest problem with these first-generation products is that they were not designed for the buy-and-hold investor; holding front-month futures and having to constantly roll into new positions can be devastating in a contango environment (but can be beneficial during backwardation)
These front-month contract funds were designed with traders in mind. For those who do trade or wish to do so, these can be very powerful investing tools. It’s not necessary to open up a complex futures account, since investors and traders can access that market through these tickers. Again, this is for those who measure their holding period in hours and days.
Unfortunately, many investors have used these first-gen products as if they were buy-and-hold funds, not understanding why they may have gotten burned over the long run.
This was especially apparent on our panel, as much of the audience was unfamiliar with the difference between these first-gen products and the newer funds, and when each investment is appropriate.
The next-generation commodity funds space is a more recent addition to the market. These products aim to provide investors with access to the futures market in a wrapper that is appropriate for a long-term investor. These funds will sometimes avoid front-month exposure altogether, often investing in multiple futures contracts at once and ensuring that the roll out of expiring contracts has minimal impact on the fund.
Teucrium has a line of funds that are some of the best examples in the industry as far as next-generation products are concerned. These ETFs provide exposure to the futures world (as well as commodities that no other fund invests in) that allows an investor to use the fund as a part of a diversified long-term strategy. Because most investors are not active traders, recent years have seen a healthy addition of next-gen ETFs pertaining to the commodity industry.
Many investors have failed to distinguish between first- and next-gen funds, simply going with the first-gen products because they have been around longer or perhaps trade more often. This is a mistake. These fund styles are designed for completely different strategies and investors.
The Bottom Line: The Right ETF for You
The commodity ETF world is one that requires a bit more research on the part of the investor, and we are here to help with that. But at the end of the day, each investor needs to understand each product and make the choice that is most appropriate for them. In some cases, you may find that ETFs are not at all appropriate for your strategy and that you are better off trading the futures yourself. Traders (or those with a full understanding of the impact of front-month rolls) may find that first-generation ETFs are the most suitable for them.
Almost all long-term investors will find that the next-generation products are much better fits for their portfolios. The key is educating yourself prior to making an investment and asking if a particular fund will be in line with your long-term goals.
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Disclosure: No positions at time of writing.