Oil, gold, energy, and the famous orange crops from the movie Trading Places are all included in a type of investment known as commodities. Adding commodities to your investment portfolio creates exposure to different investment products, and helps to reduce risk, hedge inflation, and diversify your overall investing strategy.
However, unless you’re planning to open your own microbrewery, loading the back of your truck with bags of wheat, barley, and hops is the wrong way to buy commodities. Commodity exchange-traded funds (ETFs) are an alternative way to invest in commodities that keep you from becoming the neighborhood underground tavern.
- Commodity ETFs let you invest in commodities without worrying about taking possession of the physical commodity.
- There are ETFs designed around every commodity on the market, so there is no shortage of choices.
- Commodities are volatile investments, but ETFs tend to reduce much of the risk.
What are Commodity ETFs?
Commodity ETFs are a simple way to include commodities in your investment strategy. You benefit by gaining exposure to the price and performance of any commodity without actually owning the commodity itself.
Commodity ETFs consist of stocks involved in the commodity or futures and derivative contracts that track the prices of the underlying commodities. In some cases, the ETFs track commodity indexes.
For example, one of the more popular commodity ETFs is the iShares S&P GSCI Commodity-Indexed Trust (GSG). In the case of this fund, you'll own futures contracts for different commodities like livestock, industrial metals, and agriculture assets. As a result, you gain exposure to various commodities, but you don’t have stacks of metal and herds of cattle in your backyard.
Types of Commodity ETFs
You can find commodity ETFs to fit just about any of your investing goals. There are broad-based commodity ETFs that track multiple types of commodities in one fund, like the iShares GSG. In addition, there are funds that track one particular commodity like oil ETFs, gold ETFs, and energy ETFs.
Should You Buy Commodity ETFs?
One advantage of commodity ETFs is how they simplify commodity trading for investors. Without an ETF, you would make individual purchases of commodity futures or invest in commodity-related derivatives or companies. With an ETF, you can invest in your chosen commodities without purchasing a contract or becoming involved in physical trading.
In one trade, you have instant exposure to the price and performance of a particular commodity.
Then there is the decision of which futures or companies to choose. And even if you decide to invest in a commodity index, there is still the challenge of purchasing all the equities in the index basket to target a certain price. Commissions and complexities also make it hard to achieve your investing goals.
But in the case of a commodity ETF, you make one trade at one price and save on commissions. The commodity ETF is already bundled ahead of time.
Advantages of Buying Commodity ETFs
When you include commodity ETFs in your portfolio, the best attraction is the benefits they create for investors. Capital gains taxes aren’t incurred until the sale of the ETF, which gives ETFs a tax advantage over other investment products such as mutual funds.
There is also the advantage of having a simpler trade and lower commissions and management fees, among the many other benefits of ETFs. There are some disadvantages when trading ETFs, but if you understand how they work, commodity ETFs could be a great asset for your portfolio.
How to Invest and Trading Strategies
Before you trade any commodity ETFs, make sure to conduct plenty of research. Track the performance of the price of different commodities (like coal) and watch how some of the major commodity ETFs (like KOL, which tracks coal) react to different market conditions.
There is a lot of criticism about commodity ETFs that consist of futures contracts in that they have difficulty tracking volatile commodities. However, once you do have a good understanding of how commodities and commodity ETFs interact, you can get started by including commodity ETFs and ETNs in your investing arsenal.
While there is still investing, inflation, and market risk with commodity ETFs, they give you diversity to help hedge (nut not eliminate) these risks. However, you do inherit management and trading risk with any ETF.
The following strategies can help you make your first investments in commodity ETFs:
- If you are looking to stabilize some gold investments in your portfolio, you can sell a gold ETF with one trade and help reduce your downside gold risk.
- You can also use an energy ETF to hedge the downside risk for both industry and foreign investments. If you are long a lot of energy stocks, sell an energy ETF to hedge your downside risk.
- Do you have foreign investments in a country where coal is a major source of income? This would be another opportunity to sell a coal ETF to protect the downside.
- There is the option of purchasing an inverse commodity ETF which emulates the price of a commodity index in the opposite direction. Inverse ETFs are good if you want to sell a commodity but can't short ETFs due to margin or account restrictions.
- If you don’t want to close your commodity ETF positions but want short-term exposure or protection, trading ETF options can be a good strategy.