Commodity ETFs – easy way to add oil, gold or wheat to your portfolio

Commodities are seen by many as one of the building blocks of a balanced portfolio.

In basic terms, commodities are goods that are either grown, or dug out of the ground. They are often used as inputs in the production of other goods.

Hard commodities are natural resources that are mined or extracted – things such as gold, copper and oil. Soft commodities are things that must be grown and tended to during production. They include agricultural commodities such as wheat, sugar, cotton, and livestock.

Why invest in commodities?

There are several reasons to include commodities in your portfolio:

Low correlation with other asset classes

Commodities can bring potential diversification benefits to your portfolio, as their performance historically shows a low correlation with other major asset classes such as equities, fixed income and cash.

Table 1 shows correlations between commodities, equities and bonds since 2000, as represented by:

• the S&P GSCI Light Energy Index (commodities)
• the S&P 500 Index (U.S. equities), and
• the Bloomberg Barclays Global Aggregate Unhedged USD (bonds).

Over the 19-year period since 2000, commodities had a low correlation with equities, and a correlation of close to zero with bonds.

Table 1: Commodities/U.S. equities/global bonds correlations, 2000 – 2019

Source: Bloomberg. Past performance is not an indicator of future performance.

Demographic trends

Ongoing demand for commodities is supported by rising populations and demographic trends.

Infrastructure programs in emerging economies, for example, support demand for materials such as iron ore, used to make steel, and other materials.

The demand for agricultural products is supported not just by rising populations – more mouths to feed – but also by increasing living standards. The composition of food demand changes, as increased demand for protein rich diets (meat and dairy) means more grain is required to feed livestock.

With a growing global emphasis on renewable energy, agricultural resources are also in demand for the production of bio-fuels.

How to gain commodities exposure

Investing in commodities directly tends to be impractical and costly – few investors want to take delivery of tonnes of wheat or barrels of oil!

One alternative is to invest in commodities futures. However, this too has its drawbacks – a futures trading account is needed, futures typically have large contract sizes, there are administrative demands around margining, and not least, buying and selling futures involves open-ended risk.

ETFs provide a convenient, cost-effective way of seeking to gain exposure to commodities.

There are several things to consider before investing in a commodity ETF, including:

• Do you want exposure to a single commodity, or to a basket?
• How does the ETF provide exposure to the underlying commodity?
• Is the exposure currency-hedged?

Single commodity exposure vs. basket

Some ETFs provide exposure to a single commodity, such as gold or oil.

Other ETFs provide exposure to a basket of commodities. This may be a basket focused on a particular type of commodity, such as precious metals or agricultural commodities, or a more broadly diversified basket.

For example, BetaShares’ Agriculture ETF – Currency Hedged (synthetic) (ASX: QAG) provides exposure to a basket of the four most significant agricultural commodities (corn, wheat, soybeans and sugar).

How is exposure achieved?

Relatively few ETFs gain their exposure by holding the physical commodity itself. Among the few exceptions to this rule are ETFs that provide exposure to precious metals, such as our Gold Bullion ETF – Currency Hedged, which is backed by bars of gold, held in a vault in London.

Most commodity ETFs, however, do not directly track the price of the commodity, instead they aim to track an index based on futures contracts over the commodity.

For example, our Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO) aims to track an index based on crude oil futures traded on the New York Mercantile Exchange (NYMEX).

Importantly also, while commodity spot and futures prices are correlated, you should not expect an ETF based on commodity futures to provide an identical return to holding the physical commodity itself.

Currency hedging

Commodities are priced in USD. If your exposure is not currency-hedged, you are exposed to the risk of unfavourable movements in the AUD/USD exchange rate, which can have a significant impact on performance.

The following chart shows the difference in performance between gold in AUD terms and USD terms, illustrating that while during some periods the unhedged and hedged price of gold moved approximately in parallel, at other times exchange rate fluctuations had a dramatic impact.

Figure 1: Gold Bullion spot price performance Hedged vs. Unhedged: December 1999 – June 2019

Source: Bloomberg. Past performance is not an indicator of future performance.

BetaShares currency hedges all its commodity ETFs, meaning that performance is determined by price movements in the commodity (or commodity futures) and not distorted by exchange rate movements.

To learn more about our commodity ETFs, please visit our fund overview.