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Physical Exposure: Right-Sized Commodity ETFs

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April 13, 2016
Right-Sized Commodities

We’re guessing you’re not too keen on oil drums in the backyard or sacks of raw sugar stacked on your front porch? Still, there comes a time that most investors might benefit from adding commodities to a stock-heavy portfolio. The good news is you can skip the bags and barrels. There are more efficient ways to gain exposure to these tangible assets for use as a hedge against inflation or more generally, to diversify. Commodities futures trading might fill the bill for many institutional investors, advanced retail traders, and corporations. For the littler guys, there are commodity exchange-traded funds (ETFs).

The old standby of varying asset classes to help mitigate market volatility has long included commodities—metals, oil, grains, sugar, etc. And, the earliest ETFs have been around for a couple of decades, which means that data and research are plentiful. But ETF popularity has jumped in the past five years as the number of markets they track has expanded. As such, ETFs are increasingly becoming part of the investing vernacular, especially in the wake of historic market volatility and as investors are inspired to diversify beyond the classic stock-bond portfolio composition. To this end, investors are increasingly turning to ETFs for exposure to “alternative” markets such as commodities.

While it’s true that commodity ETFs can go down in bear markets, consider that in 2008, when the S&P 500 fell over 30%, many commodity ETFs fell far less than the S&P 500.

Why Now?

Diversification is no passing fancy, but there are recurring timely market trends that may inspire a deeper look into commodities.

For instance, unusual weather patterns that included a historic drought in the U.S. Midwest in 2012 had a short-term impact on supplies, and thus prices, presenting potential opportunities for some investors. Unpredictable weather comes at a time of steadily rising (with short-term peaks and valleys) emerging-market demand for grain, meat, and the metals needed to build housing and commerce. Easy global monetary policy from major central banks, including the U.S., Japan and Europe, also raises the prospect for future inflation or a dramatic swing higher for interest rates. The timing of all this remains a major question mark for investors.

The Vitals

There are three types of commodity ETFs you might consider:

  1. Some commodity-based ETFs invest in and take delivery of actual commodities like gold and oil.
  2. Some commodity ETFs hold shares of the companies involved in commodity production and distribution (your gold miners and oil drillers, for instance). Many of the stocks in these ETFs will benefit from an increase in the price of the commodity, but there may be other factors that could decouple the basket of stocks in the ETF from the commodity itself, such as interest rates and exchange rates.
  3. Finally, there are ETFs that hold futures and/or options contracts as a substitute for the physical commodity. Keep in mind investors will still be subject to other risks associated with futures and options costs. Generally, these ETFs may lose value over time due to those costs.

Screen Test

Use a screener to narrow the field of ETFs that might best fit your goals. Pre-defined and custom screens can help you filter through sector, target-date, and bear-market funds.

Editor’s Note: This article was originally published in April 2013.

The Fine Print

Researching pricing can be an important early step to exploring commodity ETFs. Unlike mutual funds, ETFs trade any time the stock market is open and their prices are trackable on an intra-day basis.

Commodity ETF prices can be based on: the price of a commodity; the price of an index that tracks commodity prices, or the Net Asset Value (NAV) of the actual holdings or the futures contracts held by the ETF. While the ETF has a NAV, the actual price of the shares of the ETF may trade at a premium to, or a discount from, the NAV due to prevailing market forces.

Some investors may find all they need in one specific area. But because investing goals, time horizons and risk tolerance may vary, some investors may choose to invest in two or three commodity ETFs that together achieve the diversification they are looking for. Still, many investors often limit their holdings in alternative investments such as commodity ETFs to a small percentage of their overall portfolio. As with any investment, it’s important to understand the nature, composition, and costs of an ETF before committing.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.