Markets

4 Steps To Picking The Right Commodity ETF

Picking the right exchange-traded fund for your investment portfolio can be an arduous task that is often compounded by the sheer number of available offerings. In some sections of the ETF marketplace, there can be 10, 15, or even 20 competing funds that offer just slightly different variations on the same theme.

This is especially true in the commodity space through its wide variety of single-sector and diversified indexes. Many investors will default to the ETF with the longest history, lowest expenses, or largest assets under management. However, that strategy doesn’t always result in the best overall returns and can often lead to surprises in tax treatment or other unforeseen risks.

Broad-based commodity indexes have notched double digit returns so far in 2016 and are rapidly drawing interest from investors who had shunned this asset class for its half decade of underperformance. Nevertheless, before you jump into any new commodity fund, make sure you fully understand its opportunities and risks by examining these four critical factors.

Index Construction Criteria

The vast majority of ETF investors implement their commodity exposure through a specific niche such as gold, silver, oil, or natural gas. This allows you to focus on one component similar to an individual stock and reduces the emphasis on underlying index construction. By and large, the SPDR Gold Shares ETF (GLD) is going to have very similar price pattern and returns as the iShares Gold Trust (IAU).

The other side of the coin are funds with multiple physical commodities that are conglomerated in a single investment vehicle. The PowerShares DB Commodity Index Tracking Fund (DBC) is the largest of this type with over $2.5 billion in total assets. DBC tracks an index of 14 of the most heavily traded commodities, which include energy, agriculture, and metals.

In the case of DBC, particular emphasis is placed on the energy sector, which means that this fund will be heavily influenced by the price movement of the oil and gas markets. Investors who want to limit that exposure may consider an alternative such as the United States Commodity Index Fund (USCI). This ETF follows a rules-based index that selects 14 commodity futures contracts and equal weights the components. That reduces the impact that any one sector can have on the return of the fund.

As you can see on the 3-year chart below, this differing index construction methodology has created a wide performance gap between these two competitors.

Keep in mind that many times actively managed or smart-beta style commodity funds can change their holdings over time. That is why it is important to regularly evaluate the index components to ensure they are continuing to meet your needs.

Management Fees

Expenses are an important consideration when comparing any two similar investments. Often times there are widely varying costs in the underlying expense ratios, trading fees, and accurate index tracking in commodity-linked ETFs.

Returning to our prior example using gold ETFs, GLD carries a management fee of 0.40%, while IAU charges just 0.25%. IAU is 37% cheaper to own on an annual basis despite the fact that GLD has 4.5x the assets under management. Both funds provide similar liquidity and tracking to the gold markets on a daily basis.

Keep in mind that many times your broker will offer a select list of ETFs that are available commission-free. This may be a deciding factor in selecting a fund that you can systematically add to over time with no trading costs, which frees up the barriers to entry and exit.

Legal Structure

Legal structure is also another important consideration when delving into the commodity realm. The two most common structures are exchange-traded funds (ETFs) and exchange-traded notes (ETNs).

ETFs are individual pools of capital that are invested in the actual physical commodity futures contracts. The share price of the ETF and net asset value of the fund fluctuate throughout the trading day based on the change in the underlying futures contracts.

By contrast, an ETN is an unsecured debt instrument that is designed to track a commodity index. These must be issued by a bank such as Barclays and by their very nature have some level of credit risk from the fund issuer.

One example of a popular commodity ETN is the iPath Bloomberg Commodity Index Total Return ETN (DJP). These funds are often mistaken for ETFs because they look and act very similar – i.e. a liquid index that is priced throughout the trading day based on the change of its underlying components.

One of the principal advantages of selecting an ETN may ultimately come down to our last criteria, tax treatment.

Tax Treatment

The tax treatment of commodity funds is a sticky issue that must be a top point of knowledge for investors who are just getting familiar with this space. Many commodity ETFs such as DBC are required to be structured as a partnership rather than a trust in order to participate directly in the futures markets.

This means that all shareholders are going to receive a K-1 at the end of the year that doesn’t directly correlate with your gain or loss from the actual investment. Accounting for this IRS form can be a headache for taxable accounts. One benefit to accessing commodities through an exchange-traded note is that you receive a traditional 1099 tax form instead of a K-1.

The fund issuers do an excellent job of describing this tax treatment in their prospectus, which is why all investors should closely read the fine print before purchasing a commodity fund.

Furthermore, it should be noted that the tax-treatment of precious metals ETFs can be unconventional as well. Funds such as GLD, which offer exposure to the physical commodity, are taxed as a collectible. This means differing tax rates are applied versus traditional short and long-term capital gains. I recommend the primer on this subject at ETFDB.com to learn more as well as consulting with a tax professional for any individual concerns.

The Bottom Line

Commodity funds can offer a unique dynamic to your portfolio that varies from the price movement of stocks and bonds. However, they are also a mine field of potential risks that must be understood before adding them to your mix. My advice is to take the time to research these characteristics before jumping headlong into the fray.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.