What is a commodity ETF?
A commodity exchange-traded fund (ETF) provides exposure to one or more physical commodities, for example precious metals such as gold, and other resources, such as oil.
Commodity ETFs generally aim to track benchmark indices which measure the price of single commodities, a basket of commodities, or futures contracts over one or more commodities.
The structure of an ETF enables you to gain exposure to commodities without having to directly trade futures contracts or other derivatives. Investing in commodity futures can be risky and complex, requiring a futures trading account and having to deal with administrative demands such as margin calls.
How commodity ETFs work
For most investors, it is costly and impractical to invest directly in commodities, which may involve taking physical delivery of a commodity, whether it is a barrel of oil, a tonne of soybeans or even physical gold bars.
There are usually high minimum investment levels, plus the costs of storage and insurance.
As a result, commodity ETFs generally do not invest in the physical commodity itself. Instead, they invest their assets in cash, and enter swap contracts with one or more counterparties to gain exposure to the performance of futures contracts over the relevant commodity or commodities.
A notable exception is the Betashares Gold Bullion ETF – Currency Hedged (ASX: QAU), which is backed by physical gold bullion bars, which are held in a vault of JP Morgan Chase in London.
As it’s not practical to transport and store the underlying commodities, these funds aim to track the price performance of indices based on futures contracts over the commodity, hedged into Australian dollars, before fees and expenses.
Such commodity ETFs are referred to as ‘synthetic’ because they are based on financial contracts over commodities, rather than investing directly in the commodities themselves.
For example, the Betashares Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO) aims to track the performance of an index (before fees and expense) based on crude oil futures traded on the New York Mercantile Exchange.
Synthetic doesn’t mean there is nothing underlying the ETF. Betashares commodity ETFs structured in this way are 100% backed by cash, held in a separate account by a third party custodian.
What are commodity futures?
A futures contract is a contract which sets the price for delivery of a particular commodity at an agreed point of time in the future. Commodity futures are traded on futures exchanges globally – they are liquid and standardised, and utilised by commodities investors throughout the world.
Why invest in a commodity ETF?
Commodities can form a core part of a balanced portfolio, offering potential diversification benefits given the historically low correlation of commodities to other asset classes such as Australian equities or international equities, or cash and fixed income.
Gold is often seen as a ‘safe haven’ as historically, the commodity has tended to be less affected than some other asset classes by negative macroeconomic trends, such as rising inflation or political uncertainty.
However, when it comes to investing in gold, it is rare for investors to buy physical gold itself, which is why one of the most popular ways to gain exposure to the performance of gold is through buying a gold ETF.
Read here for reasons to consider adding gold to your investment portfolio.
How are commodity ETFs priced?
An ETF may seek to track the underlying spot price, where it is possible to access and store the relevant commodity, which is the case for the Betashares Gold Bullion ETF – Currency Hedged, which aims to track the spot price of gold, hedged back to the Australian dollar (before fees and expenses).
However, given the difficulty in physically storing and accessing most underlying commodities, most commodity ETFs are priced off futures contracts.
Futures pricing can be more efficient for some commodities, especially where the futures contracts help to standardise pricing, for example in agricultural commodities where quality varies between crops, seasons, and regions.
An investment in an ETF that tracks commodities futures is not the same as investing in the spot price of the commodity. As a result, commodity ETFs based on commodities futures may perform differently to the underlying commodity itself.
Considerations when investing in commodity ETFs
Most equity ETFs provide their exposure by holding a portfolio of shares. Movements in the price of the shares in the portfolio are reflected in changes in the net asset value (NAV) of the ETF, and so the ETF can be expected to closely track these movements.
Similarly, the Betashares Gold Bullion ETF – Currency Hedged (ASX: QAU) holds physical gold bullion, and so the ETF’s price is expected to closely track changes in the spot price of gold.
However, most other commodity ETFs do not work this way. As mentioned above, because it is inconvenient and expensive to buy, hold and store physical commodities like oil, wheat and wool, these ETFs gain their exposure via futures contracts.
The performance of these ETFs is therefore linked to commodity futures and may be materially different to the performance of the spot price of the commodity itself.
Understanding commodity futures is critical to understanding the performance of the Betashares Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO).
Betashares commodity ETFs
How to invest
Investing in a commodity ETF is as simple as buying and selling any share on the ASX.