Commodity ETFs: The Easy Way to Invest in Raw Materials

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

Commodity Investing Got Way Easier

Before 2004, if you wanted to invest in commodities you basically had two options. You could buy stock in a company tied to the commodity (like Exxon Mobil for oil exposure). But Gorton and Rouwenhorst (2006) showed that these equities correlate more with the S&P 500 than with the actual commodity, so you are not getting great commodity exposure.

Or you could trade futures contracts directly. Futures require margin, they do not perfectly track spot prices, and regulators have literally called them “potentially the riskiest financial products available in the United States.” Not exactly beginner-friendly.

Then ETFs came along and changed everything. State Street launched the first commodity ETF in November 2004: SPDR Gold Shares (GLD), tracking the spot price of gold. Two months later, iShares launched their Gold Trust ETF (IAU). By 2016, there were over 140 commodity ETFs with almost $80 billion in assets under management.

Now an investor with a few hundred dollars can get exposure to a broad basket of commodities through a simple stock exchange purchase. No margin accounts, no rolling contracts, no specialist knowledge required.

Four Ways These Funds Are Structured

Here is where it gets complicated. Commodity ETFs (the chapter calls them ETCs, for exchange-traded commodities) come in four different legal structures, and the structure matters a lot.

Exchange-Traded Notes (ETNs) make up 63% of commodity ETFs. An ETN is technically a senior, unsecured debt security issued by a financial institution. You do not own a basket of commodities. You own a promise from a bank (Barclays, Deutsche Bank, UBS) to pay you based on an index’s performance. The upside: minimal tracking error and tax efficiency (you only pay taxes when you sell). The downside: if the issuing bank goes bankrupt, you could lose everything. After Lehman Brothers collapsed in 2008, ETN demand dropped hard and has not fully recovered.

Grantor Trusts hold the actual physical commodity in a vault. This is how GLD and IAU work. SPDR Gold Shares literally holds London Good Delivery gold bars (400 oz. each) in HSBC’s London vaults. Investors technically own a slice of that physical gold. The catch: this only works for non-perishable goods. All eight grantor trust ETFs track precious metals (gold, silver, platinum, palladium).

Commodity Pools are partnerships registered with the CFTC that invest in futures contracts. They make up the second-largest chunk of the market. The downside is the K-1 tax form, which nobody likes dealing with.

Open-End Funds are the newest structure, with the first one launched in 2013. They are becoming more popular because they avoid the K-1 headache. Providers use tricks like offshore subsidiaries and blending futures with passive securities to stay within regulatory limits.

The Contango Problem

This is the single most important thing to understand about commodity ETFs that use futures contracts. It can absolutely destroy your returns.

When a futures contract trades above the spot price, the market is in contango. The ETF has to sell its expiring contracts and buy the more expensive next-month contracts. This creates a negative roll yield that eats into your returns month after month.

When futures trade below spot, the market is in backwardation, and the roll yield works in your favor.

Here is a real example from the chapter. Between September 2015 and September 2016, the spot price of WTI crude oil went up 7.1%. An investor in the United States Oil Fund (USO), which buys front-month oil futures and rolls them each month, lost 25.5%. That is a gap of over 32 percentage points in one year, mostly because of contango.

For gold, the story is better. The iShares Gold Trust (a grantor trust holding physical gold) tracked within 8% of gold’s spot return over about 10 years. The PowerShares DB Gold Fund (a commodity pool using futures) lagged by 39%. Same commodity, vastly different results based on the structure.

Some ETFs try to fight contango by actively picking the most advantageous futures contracts instead of just buying the front month. The PowerShares DB Oil Fund (DBO) does this. It helps, but it cannot eliminate the drag entirely when markets are persistently in contango.

Diversification Still Works

Despite the complications, the basic case for commodity ETFs in a portfolio holds up. Georgiev (2001) showed that combining a portfolio of U.S. stocks and bonds with the Goldman Sachs Commodity Index lowered the portfolio’s standard deviation by 0.9% without hurting the Sharpe ratio. For a global portfolio, the risk reduction was 0.5% while the Sharpe ratio actually improved.

Gold in particular gets used as a stand-alone hedge against inflation, currency depreciation, and geopolitical stress. That is why GLD became the eighth-largest ETF overall, with $41.5 billion in assets.

How ETFs Are Changing the Futures Markets

When ETFs buy and sell large amounts of futures contracts, it affects the underlying markets. Corbet and Twomey (2014) found that smaller commodity ETFs actually reduce volatility in futures markets by adding liquidity. But ETFs with investments above $2.15 billion increase volatility. More daily trading means more buying and selling of futures, which can make prices jumpier.

There is also a cross-correlation effect. When a diversified commodity ETF creates or redeems shares, the provider has to buy or sell futures across multiple commodities simultaneously. This has pushed correlations up between unrelated commodities. Before 2004, the correlation between soybeans and crude oil was basically zero. After commodity ETFs took off, it jumped to 0.6. Similar increases showed up between oil and cotton, live cattle, and copper.

And then there is front-running. Because ETFs publish their rebalancing schedules, speculative traders can anticipate when an ETF will roll its futures contracts and trade ahead of it. The Wall Street Journal reported that predatory traders benefit at the “little guy’s” expense through the predictable roll process of funds like USO.

However, Bessembinder, Carrion, Tuttle, and Venkataraman (2012) studied this and found that ETFs pay about 30 basis points to complete roll trades, which is similar to trading costs in large-cap equities. They found no clear evidence that predatory trading is the main cause of these costs.

What to Keep in Mind

The chapter makes a few things clear about commodity ETFs:

1. Structure matters enormously. A physically backed gold trust and a futures-based gold fund deliver very different returns over time.
2. Contango is the silent killer. If you hold a futures-based commodity ETF for the long term, roll yield can seriously hurt you.
3. Know your fees. Expense ratios range from 0.25% to 0.78% and compound over time. Commissions and taxes add more drag.
4. Leveraged and inverse ETFs are short-term tools only. Due to daily rebalancing and compounding, they do not track their target over longer periods. These are for active traders, not buy-and-hold investors.

Commodity ETFs have made commodity investing accessible to regular investors. That is genuinely positive. But accessible does not mean simple. The regulatory structures, the roll yield dynamics, and the market impact effects all require understanding before you put money in. Read the prospectus, and understand what you actually own.

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