LEVEL: BEGINNER
Exchange traded funds (ETF’s) are investment vehicles which are liquid market products that replicate the movement of an index or market sector. ETF’s allow investors to enter and exit their positions during normal trading hours. Commodity ETF’s have come into prominence during the past decade. The large run up in oil, gold and grain prices that occurred during 2007,2008, and 2012, have generated significant interest in commodity prices, which have generated additional appetite for commodity ETF’s.
ETF’s differ from mutual funds in that they provide intra-day liquidity and the ability to allow investors to exit at the current live price as opposed to an end of day price. ETFs are considered attractive as investments because of their low costs, and stock-like features.
The Makeup of a Commodity ETF
Commodity ETF’s differ from sector ETF’s in that these instruments hold commodities such as oil, gold, base metals or grains, and not the companies that produce or transport these products. Investors need to focus on what form commodities are held as assets within each ETF, making sure they are getting the correct risk exposure.
There are a number of ETF’s that are created to reflect returns that mimic the prices of specific commodities. Holding futures contracts can accomplish this effort, but investors need to make sure that the futures that are held are either prompt or deferred contracts based on the return the investors is looking to achieve.
The term structure of each futures market can also play a role in the returns of the ETF. When a market is backwardated, meaning current prices are greater than deferred prices, an ETF that holds futures will benefit as prices rise given that the manager is selling higher prompt futures to purchase lower deferred futures.
On the other hand, when a market is falling, a market in contango (where current prices are below deferred prices) will cause an ETF that is attempting track futures prices to underperform given that the manager is selling futures that are lower in price and purchasing higher deferred futures contracts.
Oil ETFs
Oil prices experienced significant attention during its climb to nearly $150 per barrel in mid-2008. Oil ETFs experienced an increase in popularity since that period as demand from retail investors propelled the appetite to speculate within the oil space. Oil is one of the most fungible global assets and the demand to speculate and hedge oil prices continue to gain interest.
Prior to the creating of oil ETF’s access to hedging oil price movements were relegated to those who had access to futures accounts, and large institutions that could use over the counter derivatives to trade the oil markets.
The most popular benchmark of oil price movement is West Texas Intermediate (WTI) crude oil which has its hub in Cushing Oklahoma, and is traded as the delivery point for the New York Mercantile Exchange (NYMEX) crude oil futures contract. WTI is a light sweet crude oil which is used to refine energy products such as gasoline, heating oil and jet fuel.
ETFs:
- United States Oil Fund (USO): This ETF has approximately 3 billion dollars in assets and hold NYMEX oil futures as its main holdings. The USO ETF is geared to follow NYMEX futures and give an accurate correlation to oil price movements. One of the benefits to holding this ETF as opposed to oil futures is that investors do not have to post initial or maintenance margin. One of the drawbacks of this ETF is that the managers need to constantly role front month futures contracts to purchase new futures contracts, creating additional expenses for this product.
- iPath S&P GSCI Crude Oil Total Return Index ETN (OIL): This investment vehicle is structured as an Exchange traded note, meaning that it is a senior unsubordinated debt security. The index also holds NYMEX WTI futures contracts.
- PowerShares DB Oil Fund (DBO): This ETF also hold WTI futures contract in an effort to track the price action of benchmark oil.
As the appetite to speculate in the oil market continues to climb, additional products have been created to speculate in these markets. There are currently more than 10 oil ETF’s along with ETF’s in heating oil, gasoline and natural gas. Additionally, ETFs have been created to short the oil market, which gives investors leverage to declining oil prices.
Gold ETFs Funds
Gold ETFs have provided investors direct access toward speculation on gold prices. Prior to the introduction of Gold (commodity) ETFs investors who wanted to speculate on the direction of gold prices needed to accomplish this by trading gold futures or gold over the counter products.
The creation of Gold ETFs have increased the liquidity of gold, and increased the volume of gold traded throughout the globe. The American Stock Exchange (AMEX) is the primary trading exchange for Gold ETFs. Gold ETFs contain assets which include gold futures contracts and physical gold.
Gold ETFs are appealing to investors as the process of transacting is relatively simple for those who own a brokerage account. Gold ETFs allow investor to purchase small portions of gold as opposed to full gold bars or even an ounce of gold which is currently 1525 per ounce.
Gold ETF Examples
SPDR Gold Trust (GLD) was the first Gold ETF fund and is currently the ETF with the largest volume of trading.
ProShares Ultra Gold (UGL) This gold ETF known as a double gold ETF, it is designed to double the investment return.
There are a number of short gold ETF’s that give investors exposure to falling gold prices.
ProShares UltraShort Gold ETF (GLL) – This double short gold ETF also trades at twice the inverse of current gold prices.
Grain ETFs
With the hot dry conditions in the mid-west during the summer of 2012, grain prices skyrocketed to new all-time highs. These types of conditions are ripe for increased appetite for products that allow investors to speculate on the direction of products such as corn, wheat and soybeans, which are the most widely traded grain products.
- The Teucrium Corn Fund (NYSE: CORN) is one of the most popular grain ETF’s as it provides investors unleveraged direct exposure to corn without the need for a futures account. The fund hold corn futures and attempts to avoid downward pressure on the NAV of the fund given the term structure of the corn market.
- Power Shares DBA Agricultural Fund (NYSE:DBA) is an index that tracks a basket of commodity products which include corn, wheat and soybeans.