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What Commodity ETF Investors Should Know

In order to provide exposure to prices of resources that don't lend themselves to physical storage, many ETFs invest in futures contracts written on the related asset. A futures contract is an agreement to buy or sell a commodity at a certain date for a predetermined price, so its value generally moves along with spot prices.

In order to avoid taking physical possession of the underlying commodities, these funds conduct a regular "roll" process, selling contracts nearing expiration and using the proceeds to purchase longer-dated futures contracts. As such, futures-based products are impacted by three factors: 1) changes in the spot price of the underlying commodity, 2) interest earned on uninvested cash, and 3) the "roll yield" incurred when near-month contracts are exchanged for longer-dated futures. If prices for future delivery are significantly higher or lower than the current price level, the third of these factors can contribute significantly to overall returns.

While the returns to futures-based commodity funds will generally exhibit a strong correlation with spot prices, the movements are often far from perfect. Perhaps the most extreme example is the United States Natural Gas Fund (UNG). In 2009, natural gas prices remained stable, but UNG (which implements a futures-based strategy) lost more than half of its value as a result of consistent contango in futures markets (see What's Wrong With UNG).

Funds utilizing a futures-based approach include UNG, the United States Oil Fund (USO) and PowerShares DB Commodity Fund (DBC).

2b. Futures-Based Commodity ETNs

Among exchange-traded commodity products relying on a futures-based strategy, there are some subtle yet extremely important nuances. A number of commodity funds are actually structured as exchange-traded notes (ETNs) that are linked to futures-based commodity benchmarks.

The UBS E-TRACS CMCI Food Total Return (FUD) is a good example. FUD is linked to the UBS Bloomberg CMCI Food Index, which measures the collateralized returns from a basket of 11 futures contracts from the agricultural and livestock sectors. FUD doesn't actually invest in these contracts directly, but is rather a debt security that pays returns based on the movement of a related benchmark.

Commodity ETNs have both potential advantages and drawbacks. Because they don't actually invest in futures contracts, ETNs will generally exhibit lower tracking error, and the management process may be more cost-efficient. But because ETNs are senior unsecured debt securities, they expose investors to the credit risk of the issuer. In the case of a bankruptcy, there are no underlying assets to be distributed to investors. Most ETN issuers maintain very high credit ratings, but the risk of default should never be completely written off.

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