There are many ways to classify commodity ETFs. One alternative is by the type of commodity they track, such as gold or oil. Another is by the type of investment product they use. There are three common types of commodity ETFs by the type of investment: physical commodities, futures-based, and equity-based. Understanding the nuances of these different investments is important when considering commodity ETFs.
Physically backed commodity ETFs invest directly in the physical commodity, and issue shares backed by the physical inventory. The largest physically backed ETF is the SPDR Gold Shares with $50 billion in assets. This is more gold than the official gold reserves of Switzerland or China. Important considerations for physically backed ETFs are the cost, safety and permanence of storing the commodity. Storage and insurance costs can be prohibitive for a commodity such as oil. Storing perishable agricultural commodities is not only expensive but also impractical. As a result, most physically backed ETFs invest in precious metals, such as gold, silver or platinum, which can be stored for long periods of time without losing their value and where the cost of storage is low relative to the value of the commodity.
Futures-based commodity ETFs invest in futures contracts for the particular commodity it tracks. An example is the U.S. Natural Gas Fund, which has $2.5 billion in assets. There has been a lot of negative press about futures-based ETFs, the most recent one from Bloomberg Businessweek (“Amber Waves of pain”, July 22, 2010). The article chronicled two problems that caused the returns of futures-based commodity ETFs to significantly lag the return of the commodity itself. The first one has been well documented and is caused by the fact that many commodity markets have been in contango for quite some time. The article suggests a second, more sinister problem with futures-based ETFs. Because the ETFs roll the futures contracts at set times, “professional futures traders exploit the ETFs’ monthly rolls at the little guy’s expense.” U.S Commodity Funds, the firm behind the U.S. Natural Gas Fund, is launching a futures-based commodity ETF that seeks to avoid the contango issue by concentrating in commodities that are in backwardation, which is the opposite condition to contango. Contango: when the future price of a commodity is higher than the current (spot) price.)
Some futures based funds are structured as Exchange Traded Notes (ETNs), which have the additional counterparty credit risk exposure to the bank selling the notes. An example of a futures-based commodity ETN is the iPath Dow Jones-UBS Platinum ETN, which is exposed to the credit risk of the issuer, Barclays Bank PLC.
Equity based commodity ETFs do not invest in the physical commodity but rather buy shares of companies involved in the commodity. An example if the Market Vectors Gold Miners ETF which invests in shares of gold mining companies. The returns of these funds, while correlated with the price of the commodity, do not track the prices of the underlying commodity. These funds tend to be more volatile than the price of the commodity, and typically rise faster than the price of the commodity when commodity prices increase, but also fall faster than the price of the commodity when commodity prices decline.
The following chart from the Journal of Indexes article “Rethinking Investing in Commodities,” May/June 2010, shows the performance of three types of commodity based indices since 2003: equities, physical, and spot, and compares them to the return of the S&P 500. Equity based commodity indices performed best during this period followed by the spot index. Futures-based indices performed worse among these three types of commodity indices but still managed to beat the returns of the S&P 500 during that period by a small margin.
Source: Journal of Indexes, “Rethinking Investing in Commodities,” May/June 2010
In summary, not all commodity ETFs are created equal and have different structures, risks, and returns. The following table shows a sample of commodity based ETFs and ETNs across these three types of commodity based investments, equities, physical and futures-based commodities:
Read more: http://www.businessinsider.com/not-all-commodity-etfs-are-created-equal-2010-8#ixzz0x6Ogo7LG
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