By Michael Johnston, founder of ETF DatabaseIt'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:
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).
Many of the commodity products offered by iPath and UBS are structured as ETNs.