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Should you own commodity ETFs?

Commodity investing has become very popular over the last number of years, but it may not be right for everyone.

Andrew Hepburn 13 October, 2016 | 5:00PM
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Following the commodity crash of late 2014 to early 2016, investors didn't press the sell button. They rushed back in to buy. According to BlackRock, exchange-traded commodity products have seen worldwide net inflows of US$33.6 billion since the start of the year. Research by Barclays published in early August said that 2016 has seen the most interest in the sector since 2009. That year marked the start of a bull market in resource prices which lasted until 2011.

But does this mean the average investor should get in on the action?

Commodity ETFs explained

Before commodity ETFs were introduced, the public had no practical way of accessing markets such as those for grains or oil.

In general there are two types of commodity ETFs. The first variety holds and stores a physical commodity. These ETFs, which are dominated by precious metals, track the price of the underlying commodity quite closely; an example is iShares Gold Trust (IAU). The second variety owns commodity futures contracts. A futures contract gives the owner the right to take delivery of a commodity. But in practice, futures-based commodity ETFs never do.

As the commodity ETF landscape has evolved over the years, the choices available to investors have widened considerably. Investors can purchase ETFs tied to numerous energy, metal and agricultural commodities. Some ETFs are linked to one commodity, such as oil. Others comprise multiple commodities in one sector -- base metals, for instance. With the basket approach, an ETF will have different weightings for each commodity it seeks to track. In their broadest form, there are commodity ETFs that attempt to track a large, diversified basket of resource prices. One such ETF, the iShares S&P GSCI Indexed Trust (GSG), is linked to 24 different commodity futures.

Canadian investors can purchase commodity ETFs on the TSX, with Horizons, Purpose, iShares and Auspice Capital offering products tied to crude oil, natural gas and precious metals:

  • Silver Bullion Trust (SBT)
  • Horizons NYMEX Natural Gas (HUN)
  • iShares Gold Bullion (CAD-Hedged) (CGL)
  • Canadian Crude Oil Index (CCX)

For those looking to profit from declines in commodity prices, Horizons also offers inverse commodity ETFs and, for more aggressive investors, leveraged (bullish and bearish) commodity ETFs.

Not for the faint of heart

Commodity prices tend to be very volatile; a well-timed foray can pay off handsomely and in short order. The risks, however, are similarly high. Take the Teucrium Wheat Fund (WEAT), a U.S.-traded ETF that closed at US$9.59 per share on June 8. But by the end of August, following a sharp decline in wheat prices, the ETF had fallen by 26.5% to US$7.05.

Commodity returns have been less than stellar

Despite the popularity of commodity ETFs, their returns for most investors have been dismal. Recent commodity price crashes have contributed to the disappointment. But there's more to the story, involving the way futures-based ETFs work.

As Morningstar's director of research, Dr. Paul Kaplan, explains in this video, ETFs that own commodity futures are constantly "rolling" those contracts forward. They sell one that is about to expire and purchase one that will mature at a later time. When the contract that is being sold is priced lower than the one being bought to replace it, a futures-based ETF suffers a loss. Over time, these losses can add up, eclipsing any gains in commodity prices.

It may seem like a technicality, but Kaplan reminds investors that the devil is in the details with these commodity ETFs. "When you're going into one of these products via an ETF, you really need to understand these subtleties, because the returns that you get from the ETF may be quite different than what you're expecting," he says.

That's exactly what happened between 2004 and 2015, according to research by Duke University professor Campbell Harvey and former commodities portfolio manager Claude Erb. The S&P GSCI Commodity Index rose 3.39% annually on average in price, but lost 7.9% on average yearly due to the effects of rolling futures contracts. As a result, the net loss was 4.58% on an annualized basis. Imagine buying a stock, the researchers suggest, that goes up in price over 3% every year, but has a (theoretical) negative dividend yield of almost 8%. Every year, you would fall further and further behind.

Some argue that investors should buy commodities for diversification purposes. However, research published in 2013 by the Bank for International Settlements (the so-called central bank for central banks) contradicts this oft-held assumption. In their report, the authors show that since September 2008, commodity and equity prices have actually become more correlated. They also predict that adding commodities is likely to make a portfolio more volatile.

Who should buy commodity ETFs?

Before Canadian investors purchase a commodity ETF (of the bullish kind), they should remember that energy and materials stocks account for just over 30% of the S&P/TSX Composite Index, meaning they may already have significant exposure to resource prices via mutual funds and index funds. Adding more may not be a prudent move for many investors.

For investors with a high risk tolerance and a solid understanding of commodity markets, these ETFs may be appropriate. However, commodity ETFs should not be approached as ultra-long-term holdings; at some point you do need to sell. Ask anyone who regrets not selling an oil ETF when crude prices plunged from US$100 per barrel to less than US$30.

Morningstar's director of personal finance, Christine Benz, doesn't see commodities as "a must-own for investors." Owing to their riskiness and the negative roll yield in futures ETFs, Benz believes these should be, at best, "a small portion of a portfolio." Indeed, for many investors, it might be best to take a complete pass.

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About Author

Andrew Hepburn

Andrew Hepburn  Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, RateHub.ca and Canadian MoneySaver.

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