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What Commodity ETF Investors Should Know

By Michael Johnston, founder of ETF Database

It's difficult to put a finger on the exact cause of the recent surge in popularity of commodity investing. More than likely, the boom is attributable to a number of different factors. Correlation between international equity markets (and even between stocks and bonds) has surged in recent years, increasing both the importance and difficulty of adding noncorrelated assets to investor portfolios. Given the relatively weak correlation with other asset classes, commodities have found a home in many investors' portfolios.

Moreover, unprecedented injections of liquidity into the financial system have created anxiety over a coming uptick in inflation that could erode returns to stocks and fixed-income instruments. Commodities have historically served as an effective inflation hedge, and many are once again turning to natural resources to protect assets from a surge in the CPI.

Regardless of the cause, commodity investing is hot, and many investors have turned to ETFs as a way to gain commodity exposure. There are three primary ways to gain exposure to commodity prices (as well as two spinoffs) through exchange-traded products, and each can potentially offer a very unique risk and return profile:

1. Physically-Backed ETFs

The most efficient way to gain exposure to changes prices of natural resources is to actually buy and hold the underlying commodity. Portfolios utilizing this strategy will ensure a near perfect correlation with the spot price of the commodity, because the value of the underlying holdings will move in unison with market prices.

Unfortunately, the physical properties of many commodities make physical storage impractical or prohibitively expensive. The physically backed exposure approach only makes sense for commodities that 1) are nonperishable, 2) are easily stored, and 3) maintain high value-to-weight ratios.

As such, the universe of physically backed ETFs is essentially limited to precious metals funds that store bullion in secure vaults. Commodities available through physically backed ETFs include gold, silver, platinum and palladium.

2. Futures-Based Funds

While the physically backed ETF structure works well for precious metals, a similar approach obviously wouldn't work with the majority of commodities. A physically backed livestock ETF would be a potential disaster for obvious reasons, while the storage costs and logistical headaches associated with a fund storing barrels of oil or bushels of wheat would likely necessitate a double-digit expense ratio.
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