Investing in commodity ETFs – what investors need to know

Our day to day choices are impacted by the availability of basic goods, or commodities.

Commodities are a raw material or agricultural product that can be bought and sold, like coffee, wheat, gold or oil. Certain commodities, like precious metals can also act as both a store of value and a potential hedge against inflation.

Their prices fluctuate based on supply and demand and often move in the opposite direction of shares. This means they tend to increase in price when shares fall and vice versa.

The issue for most investors, is investing directly into commodities is difficult. After all, it’s unlikely you’ll want to hide gold nuggets under your mattress or barrels of oil in the garage.

That’s where commodity Exchange Traded Funds (ETFs) come in.

Investing in commodities isn’t right for everyone though, and whether it’s suitable for your portfolio will depend on your investment goals and level of risk tolerance.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments can fall as well as rise in value, so you could get back less than you invest.

What are commodity ETFs?

Exchange Traded Funds (ETFs) are a basket of investments including shares, bonds and commodities that normally aim to track an index. They’re listed on the stock market and trade throughout the day, similar to ordinary shares.

Commodity ETFs provide a steppingstone for investors to get easier and cheaper access to commodities. They’ll often focus on a single commodity and then track its price. But like shares there’s an array of options, with each offering something different.

These are the most common commodity ETFs available:

• Equity funds
• Physically backed funds
• Futures-based funds
• Exchange Traded Notes (ETNs)

Equity funds

Equity ETFs typically buy shares in companies involved with the production, transport and storage of the commodity. They help diversify across a number of sectors, but in a much cheaper way than buying each share individually.

These types of funds tend to have lower charges. But there are also lots of factors that can affect the performance of the companies in the fund. So their share price might not accurately reflect how the commodity actually performs.

Physically backed funds

As the name implies, physical backed ETFs actually hold the commodity itself. This is currently only for precious metals and they’re usually stored in banks on behalf of the fund. The advantage is investors take a stake in the fund’s deposit of metals, without having to worry about storing it. Investing in the commodity directly can also improve the chances of being able to track its price more closely over time.

These funds do all the hard work and sort the delivery, holding, storing and insuring of the commodity – but these costs add up. Physically backed ETFs can be simpler, but the underlying costs could be higher, which can impact how well the fund does.

Futures-based funds

Instead of physical assets, these funds build a portfolio of derivative contracts like futures, to track the commodity. Future-based funds are common with oil and natural gas as they’re difficult to stockpile unlike precious metals.

One of the biggest advantages of these types of funds is they’re not subject to holding and storing costs. But there are risks with the futures contracts themselves.

Futures have certain expiry dates, and the ETF will need to replace them when they’re close to expiring. This can be costly and can mean over the longer term investors will likely get a return that’s quite different from what they expected.

Exchange Traded Notes (ETNs)

ETNs are debt issued by banks. They’re backed by the issuer (the bank) and aim to match the returns of the underlying investment. They do this by buying investments, like stocks and bonds or derivatives which replicate that performance.

There’s usually only a small tracking difference between the ETN and the commodity itself. However, they’re subject to the credit quality of the issuer, which increases their risk. If the issuing bank were to fail, your investment could be worthless.

Hedging for inflation?

Inflation tends to be a good sign in a healthy economy, it’s often a signal of an economy gathering pace and generating growth. But too much of it can be hard to control. That’s why the Bank of England currently has an inflation target of 2%.

Higher inflation can often put pressure on the performance of stocks and bonds, so what about the alternatives?

Commodities, particularly gold, are often referred to as an inflation hedge – something that could potentially provide a return, when other assets like shares are being hit hard though of course there are no guarantees. Commodities like precious metals tend to hold their value and can provide an alternative investment solution when inflation is high. However, the relationship between commodity prices and inflation has come into question in recent years and it’s certainly not perfect.

Whatever your view on inflation, investors should be cautious. Gold, silver and other commodities are volatile – we think investing anything over 5% of a portfolio in them is very adventurous.

What does all this mean for investors?

Commodities can help add diversification to your portfolio, helping to spread your risk across a variety of different investments.

Physically backed funds offer you a way to invest in a commodity itself, reflecting the forces of supply and demand in the market, but they’re only available for precious metals.

Equity funds offer a more diverse approach, focusing on the various companies involved with the commodity. You’re able to invest directly into these companies, but they are subject to other influences, so the price might not track the underlying commodity as accurately as physically backed funds.

Futures and ETNs offer certain advantages like not having to store the commodity directly. However, they come with their own risks, like more complex trading strategies and potential credit risk.

Investors should remember though, just because an investment might have oil or gold in the title, there’s likely a lot more to it than first meets the eye. Looking into what a commodity ETF invests in is crucial in understanding how the investment works.

Commodity ETFs are higher risk investments and should only be considered by more experienced investors. That’s because there are lots of factors that can impact how they perform.

The Key Investor Information for each ETF is available through the HL website. These cover the key risks for each individual fund – you need to read this carefully before you invest.

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