Hidden Risks of Commodity ETFs - Investing Shortcuts

Hidden Risks of Commodity ETFs

By September 13, 2016Futures
Hidden Risks of Commodity ETFs

Exchange Traded Funds (ETFs) hold $2.17 trillion in assets. Almost every investment style is represented. ETFs based on commodities’ prices may help investors hedge against inflation and round out their asset allocation.

Commodities represent a range of resources, from Precious Metals to Energy to Agricultural. It is reasonable for an investor in a commodity-based ETF to expect the performance of the ETF to match closely that of the underlying commodity it is designed to track. Curiously, the results an investor experiences with a commodity ETF depend upon its design. This shortcut should help raise the awareness of where hidden risks may lurk within these ETFs.

An ETF that invests in and holds the physical commodity, should track the spot price closely. GLD is an ETF that holds gold and its performance does move with the London Spot Price. However, most commodity ETFs are composed of futures contracts, and it is these ETFs that hold risks of which an investor should be aware.

Because futures contracts expire, ETF managers must replace the expiring contracts with new contracts. This process is called “rolling.” If futures are priced such that longer-dated futures are priced lower than the spot price and near-term futures, the market is said to be in ‘backwardation.’ This structure benefits the ETF as expiring contracts are replaced with lower-priced contracts. This effect is known as a “positive roll yield.”

However, if the opposite is true, i.e. longer-dated contracts are priced above near-term contracts, the market is said to be in “contango”. Under this condition, the expiring contracts are replaced with more expensive ones. This “negative roll yield” is a hidden cost to the ETF and leads to the ETF lagging the spot price of the commodity. Most commodities are in contango, costing investors the difference between the expiring future and the longer-dated future every time the position is rolled.

Fortunately for investors, there are commodity-based ETFs that are constructed specifically to avoid the negative impact of contango – of which one way is to hold futures of more than one expiration.

If you currently invested in or considering adding commodity ETFs to your asset allocation, make sure you understand if hidden risks may be waiting for you. Do the research.

Elliot Katz

Author Elliot Katz

Elliot Katz has over 30 years of experience in the stock, options and futures markets. He has served as an options strategist and an institutional options broker. From 1989-1992, he was an instructor for The Options Institute of the CBOE. Throughout the 1990’s and early 2000’s, Elliot had roles in Senior Management at national wirehouses and private banks. Since 2007, he has worked as an independent advisor, trader, and educator.

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