With their healthy dose of volatility, commodities markets hold enormous profit potential for all kinds of traders, including the majority of retail traders and investors. However, the biggest commodity market trading products, futures, are typically used by commodity businesses and institutional investors. In this article, we cover commodity ETFs – a product that can serve as a great entry point to commodities trading for retail traders and long-term investors.
Commodity ETFs as an Alternative to Commodity Futures
Futures have been the primarily financial product used in commodities markets for many years, in fact for centuries. Modern commodity futures have a lot of flexibility and great liquidity, making them indispensable to the major commodity market players.
However, futures are most suited to the needs of larger entities – institutional investors and commodity businesses trying to protect themselves from seasonal or other forms of market volatility. Futures are far less popular among retail investors. There are significant risks and entry barriers in the futures market that make this product less common among individual traders and investors. Given the volatility of commodities and the significant leverage used in futures trading, using these products by investors who are not commodity experts might turn into a dangerous exercise.
At the same time, many retail investors and traders would like to diversify their portfolios by gaining some exposure to commodities. The volatility of the commodities market also means significant profit potential – something that many retail investors realize and ideally would like to benefit from.
As a retail investor, how could you gain exposure to commodities, without risking a swim in the largely unfamiliar and dangerous waters of the futures market? Commodity ETFs could be the perfect product for this purpose. These ETFs come in three different forms, each with its own mechanism of exposure to commodities.
Types of Commodity ETFs
The first type of commodity ETFs is stock-based commodity ETFs. These ETFs track a combination of stocks in companies from the commodities sector. These could be the actual producers of commodities as well as other key commodity market players – buyers, transportation and storage companies, resellers, and more.
Technically speaking, these ETFs don’t let you participate in the commodities market directly. You still remain within the realm of the stock market. However, many commodity-based stocks have volatility levels comparable to the actual underlying commodities they are involved in. Their seasonal volatilities are also often in line with the seasonal changes in the underlying commodity. As such, ETFs based on these stocks are a great way to benefit from the high-risk/high-reward nature characteristic of the commodities market.
The second type of commodity ETFs is physically-backed commodity ETFs. These ETFs physically hold the underlying commodity. Unlike stock-based commodity ETFs, physically-backed ETFs are directly linked to the commodities market by holding the asset.
Physically-backed ETFs are limited mostly to precious metals. They are only suitable for traders with the intent to hold commodities from this asset class.
The third commodity ETF type is futures-based commodity ETF. These ETFs track commodity futures or a combination of futures rather than stocks or physical commodities. They are great for gaining exposure to commodity futures without actually getting involved directly in trading them. However, do note that these ETFs aren’t always good at closely tracking very volatile commodities.
Commodity ETFs vs Commodity Futures – Pros and Cons
Commodity ETFs have a number of distinct advantages, especially for retail traders, compared to commodity futures:
1. Accessibility. This is undeniably the biggest advantage of commodity ETFs. These products are much more accessible to an average retail trader than commodity futures.
2. Simplicity. Commodity ETFs are much simpler products than futures. They are also much more familiar to most retail traders than futures products.
3. Tax benefits (in the case of futures-based commodity ETFs). When you sell shares in futures-based ETFs at a profit, there are no capital gains to report.
4. Portfolio diversification. Commodity ETFs based on physical precious metals and futures are a direct way of accessing the commodities market for retail investors. Many of these investors have an overreliance on stocks and bonds in their portfolios, and the ETFs are a great way to diversify away from the overreliance.
5. Great for long-term investment in commodities. If you have long-term goals for your commodity investment, ETFs are an ideal product. While there are plenty of multi-year futures contracts, in general, futures are a product best suited to short-term and medium-term trading. For anything with a multi-year focus, commodity ETFs are exactly what you need.
Commodity ETFs are certainly not without their drawbacks in comparison to futures. These are:
1. Somewhat higher fees. Futures are a highly liquid product with lower fees than ETFs. For instance, unlike futures, nearly all ETFs have a management fee.
2. Less accuracy in tracking the underlying asset. Compared to futures-based ETFs, commodity futures are more accurate when it comes to tracking the price of the underlying asset as closely as possible. The lower accuracy of futures-based ETFs is particularly pronounced in the case of more volatile commodities.
3. Limited leverage opportunities. Standard ETFs are not based on the use of leverage. Of course, you could invest in leveraged ETFs. However, the leverage multiples and choices in the ETF market are much more limited compared to the futures market, where leverage is a very commonly used, and sometimes overused, tool.
Recapping, we would like to note that commodity ETFs are a great, simple, familiar, and affordable way for most retail investors to access the world of commodities. These products are particularly useful if your commodity investment goals are long-term oriented.