Commodity exchange-traded funds are ETFs that invest in hard and soft commodities. Commodities are raw materials — e.g. grain, precious metals, livestock, energy products — used for direct consumption or to produce other goods. Crude oil, corn, and copper are examples of commonly traded commodities.
Investing in a commodity ETF can offer exposure to one or more types of commodities within a single vehicle. There are different types of commodity ETFs to choose when building a diversified portfolio.
What Is a Commodity ETF?
A commodity ETF is an exchange-traded fund that specifically invests in commodities or companies involved in the extraction or production processing of commodities.
An ETF or exchange-traded fund combines features of mutual funds and stocks, in that they offer exposure to an underlying group of assets (e.g. stocks, bonds, derivatives). But unlike mutual funds, ETFs trade on an exchange.Whether you have broad or narrow exposure to commodities within a single ETF can depend on how it’s managed and its objectives.
Like other exchange-traded funds, commodity ETFs can be bought and sold inside a brokerage account. Each fund can have an expense ratio, which determines the cost of owning it annually, and brokerages may charge transaction fees when you buy or sell shares.
Commodity ETFs fall under the rubric of alternative investments, which also applies to private equity and hedge funds.
💡 Quick Tip: Alternative investments provide exposure to sectors outside traditional asset classes like stocks, bonds, and cash. Some of the most common types of alternative investments include commodities, real estate, foreign currency, private credit, private equity, collectibles, and hedge funds.
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How Do Commodity ETFs Work?
Commodity ETFs are pooled investments, with multiple investors owning shares. The fund manager determines which commodities the fund will hold and when to buy or sell holdings within the fund. When you buy shares of a commodity ETF, you invest in everything that’s held within the fund.
In many cases, that includes commodities futures contracts. A commodity futures contract is an agreement to buy or sell a set amount of a commodity at a future date for a specified price. That’s an advantage for investors who may be interested in trading futures but lack the know-how to do so.
A commodity ETF may follow an active or passive management strategy. Many commodity ETFs are structured as index funds. An index fund aims to track and match the performance of an underlying benchmark. These types of commodity ETFs are passively managed.
Actively-managed funds, by comparison, typically aim to outstrip market returns but may entail more risk to investors.
Types of Commodity ETFs
Commodity ETFs aren’t all designed with the same objectives in mind. There are different types of commodity ETFs you might invest in, depending on your goals, diversification needs, and risk tolerance.
Here are some of the most common ETF options commodities investors may choose from.
Physically Backed ETFs
A physically backed ETF physically holds the commodity or commodities it trades. For example, a physically backed ETF that invests in precious metals may store gold, silver, platinum, or palladium bars in a secure vault at a bank.
It’s more common for physically backed ETFs to hold hard commodities like precious metals, since these are relatively easy to transport and don’t have a shelf life expiration date. It’s less likely to see physically backed ETFs that invest in agricultural goods like wheat or corn, as they cannot be stored for extended periods.
Futures-Based ETFs
Futures-based ETFs invest in commodities futures contracts, rather than holding or storing physical commodities. That can reduce the overall management costs, resulting in lower expense ratios for investors.
A futures-based ETF may hold commodities contracts that are close to expiration, then roll them into new contracts before the expiration date. Depending on the price of the new futures contract, this strategy may result in a cost or gain for investors.
Commodity Company ETFs
Commodity company ETFs invest in companies that produce or process commodities. For example, this type of ETF may invest in oil and gas companies, cattle farming operations, or companies that operate palm oil plantations.
These types of commodity ETFs are similar to equity ETFs, since the investment is in the company rather than the commodity itself.
Examples of Commodity ETFs
Commodity ETFs are not always easily identifiable for investors who are new to this asset class. Here are some of the largest commodity ETF options with a focus on mitigating inflation.
• SPDR Gold Trust (GLD). SPDR Gold Trust is the largest physically backed gold ETF in the world. The ETF trades on multiple stock exchanges globally, including the New York Stock Exchange (NYSE) and the Tokyo Stock Exchange.
• Energy Select Sector SPDR Fund (XLE). This commodity ETF invests in companies in the energy industry, including oil and gas companies, pipeline companies, and oilfield services providers.
• Invesco DB Agriculture Fund (DBA). The Invesco DB Agriculture Fund tracks changes in the DBIQ Diversified Agriculture Index Return, plus the interest income from the fund’s holdings. The index itself is composed of agricultural commodity futures.
• First Trust Global Tactical Commodity Strategy Fund (FTGC). This commodity ETF is an actively managed fund that offers exposure to energy commodities futures.
• Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC). PDBC is another actively managed ETF that invests in commodity-linked futures and other financial instruments offering exposure to the most in-demand commodities worldwide.
Pros and Cons of Commodity ETFs
Commodity ETFs have pros and cons like any other investment. It’s helpful to weigh both sides when deciding whether this type of alternative investment aligns with your overall wealth-building strategy.
Pros
• Diversification. Commodity ETFs can offer a very different risk/return profile than traditional stocks or bonds. Commodities in general tend to have a low correlation with stocks, which can help spread out and manage risk in a portfolio.
• Inflationary protection. Commodities and inflation typically move in tandem. As the prices of consumer goods and services rise, commodity prices also rise. That can offer investors a hedge of sorts against the impacts of inflation.
• Access. Direct investment in commodities is generally out of reach for the everyday investor, as it may be quite difficult to hold large quantities of physical goods or raw materials. Commodity ETFs offer a simple and convenient package for investing in commodities without taking physical possession of underlying assets.
Cons
• Volatility. Compared with other investments, commodities can be much more susceptible to pricing fluctuations as supply and demand wax and wane. Unexpected events, such as a global drought or a war that threatens crop yields, can also catch investors off guard.
• No dividends. While some ETFs may generate current income for investors in the form of dividends, commodity ETFs typically do not. That could make them less attractive if you’re looking for an additional stream of passive income or are interested in reinvesting dividends to buy more shares.
• Cost. Physically backed ETFs may pay storage fees to hold underlying commodities. Those costs may be folded into the expense ratio, making the ETF more expensive for investors to own.
Why Invest in Commodity ETFs?
Commodity ETFs can be worth investing in for those who wish to hedge against inflation or generate positive returns when stocks appear to be faltering. They also represent a more accessible alternative to direct investment in commodities, which may be difficult for an individual investor to manage.
Investors who are already trading futures contracts or are learning how to do so may appreciate the accessibility that commodity ETFs can offer. Commodity ETFs tend to be highly liquid, meaning it’s relatively easy to buy and sell shares on an exchange, a feature other alternative investments don’t always share.
A commodity ETF may be less suitable for an investor who has a lower risk tolerance or isn’t knowledgeable about the commodities market or futures trading. Talking to a financial advisor can help you determine whether commodities are something you should be pursuing as part of your broader investment plan.
💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).
Tax Considerations When Holding Commodity ETFs
The type of commodity ETF you invest in can determine their tax treatment. Futures-based ETFs, for example, may experience losses or gains as contracts that are approaching expiration are replaced with new ones. Additionally, commodity ETFs that hold gold, silver, platinum, or palladium may be subject to a higher capital gains tax rate as the IRS considers precious metals to be collectibles.
Furthermore, the IRS 60/40 rule specifies that 60% of commodity capital gains or losses will be treated as long-term, while 40% are treated as short-term capital gains or losses for tax purposes. This rule does not consider how long you hold the investments, which could make commodity ETFs less favorable for investors who hold assets for one year or more.
It’s also important to be aware of how a commodity ETF is structured legally. Many operate as limited partnerships (LPs), which means they pass on annual income and gains or losses as a return of capital. Investors bear the responsibility of reporting their portion of fund profits and losses on Schedule K-1. If you’re not familiar with how to do so, that could add another wrinkle to your year-end tax prep.
The Takeaway
Adding a commodity ETF or two to your portfolio may appeal to you if you’re hoping to add some diversification to your holdings, and are comfortable with a potentially more volatile investment. When deciding which commodity ETFs to invest in, it’s wise to consider the underlying investments and the fund’s overall management strategy, as well as the fees you’ll pay to own it.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Why is it risky to invest in commodities?
Commodities can be volatile. Commodity prices depend on supply and demand, which can change dramatically owing to weather patterns, technological innovations, supply chain issues, and more.
Do commodity ETFs pay dividends?
Commodity ETFs typically don’t pay dividends to investors, regardless of which type of ETF you have. The goal of investing in commodity ETFs is more often capital appreciation rather than current income.
Is it better to trade physical commodities or ETFs?
For most investors, trading raw material commodities simply isn’t feasible. There are issues of transport, storage, insurance, and liquidity. For that reason, commodity ETFs have emerged to give investors exposure to desired commodities without the physical demands.
Photo credit: iStock/Nastassia Samal
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