Commodity ETFs | Charles Schwab

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Commodity ETPs

Commodity ETPs are exchange-traded products (ETPs), including exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that provide exposure to the price changes of raw materials, such as agricultural goods, natural resources, or metals.

• What are commodity ETPs?
• Why have them in your portfolio?
• What are some common types of commodity ETPs?
• What are the pros and cons?
• What is market contango and what is backwardation?

What are commodity ETPs?

Commodity ETPs may invest in companies involved in commodities, such as natural resources or mining, or they may invest directly in commodities and are frequently structured in one of two ways:

• Physical commodity:

  Some commodity ETPs can buy and store the physical commodity itself. Commodity ETPs can be structured as trusts that use their assets to buy gold bullion to store in bank vaults.

• Futures-based products:

  The second structure for commodity ETPs is futures contracts. These trade on exchanges, similar to stocks and bonds, and don't require storage like a physical commodity does. When a futures contract approaches the delivery date, the holder will typically "roll" that contract in exchange for another contract on the same commodity to be delivered further in the future.

Some commodity ETPs provide a low-cost way to access asset classes that might otherwise be difficult to invest in and can help you diversify your portfolio.

What are some common types of commodity ETPs?

Within the commodity category, you can obtain broad or narrow exposure to single commodities or baskets of commodities. Some products are even actively managed baskets of various commodities based on different strategic benchmarks and various other factors. Here are some examples of common types of commodity ETPs:

• Grantor Trusts

  Invest in physical commodities, typically gold or silver bars, which are stored in secure vaults.

• Limited Partnerships

  Invest in commodity futures. A commodity futures contract is an agreement to deliver or receive a certain commodity at a certain date in the future for a price agreed upon today. Investors in these types of ETPs will receive K-1s at tax time.

• Actively Managed

  Some actively managed ETFs are able to invest in commodity futures but avoid distributing K-1s to investors by holding futures contracts within Cayman Island subsidiaries. These Cayman Island trusts invest in commodity futures contracts and other derivatives on behalf of the fund.

• Exchange-Traded Notes (ETNs)

  ETNs consist of a promise by an issuer to repay the face value plus the return on a referenced commodity index, minus fees. Unlike ETFs, ETNs are not registered as investment companies and are debt notes not secured by any underlying assets or securities; as a result, the creditworthiness of the issuer should be monitored. Note that ETN issuers may accelerate the redemption of certain ETNs at their discretion. Alternatively, issuers can delist the ETN from national exchanges and suspend new issuance.

• Commodity Producers

  Some ETFs primarily hold the stocks of commodity-producing companies, such as gold-mining or oil-drilling firms. While the performance of such companies does depend somewhat on the price of the commodity, these funds may perform more in line with other stock ETFs than with commodity prices.

What are the pros and cons of commodity ETPs?

To help you determine if commodity ETPs are right for your portfolio, it’s important to examine some of the benefits and risks.

• Pros

  Portfolio diversificationMany investors turn to commodities for diversification to mitigate inflation.

• Cons

  VolatilityInvestments in commodities can be volatile. Allocating more than 5%–10% of a portfolio to commodities may reduce the diversification benefits.

  Potential exposure to futuresInvestments in futures-linked commodities carry risk that the price will not directly trade, and can perform differently than, the spot price for the commodity itself. Commodity futures-linked products may also be impacted by contango and backwardation.

Contango is when the future price is above the spot price. Contango occurs when investors are willing to pay a premium today to be sure of the price they'll get in the future. If the market for a particular commodity suffers from strong, persistent contango, an ETP that buys futures contracts on that commodity will perform worse than the spot price of the commodity over time as lower-valued, near-term contracts are consistently replaced with higher-valued, longer-dated contracts.

Backwardation is the opposite of contango. It means that the futures price is lower than the spot price. In backwardation, contracts tend to increase in value as they approach maturity.

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