Commodity ETFs: How to Invest in Commodities Through ETFs

Commodity exchange-traded funds (ETFs) can provide exposure to various markets, including oil, gold, natural gas, industrial metals, and agricultural commodities without requiring direct ownership of the underlying commodity itself. While some funds hold physical commodities, others involve futures contracts and shares of companies involved in production. That means that commodity ETFs with similar names may have very different holdings, costs, and performance characteristics.

This guide outlines how commodity ETFs work, the types available, associated costs, risks, and more.

What is a commodity ETF?

An exchange-traded fund (ETF (opens in a new tab)) is an investment fund that holds a collection of different assets, such as stocks, bonds, and commodities. Commodity ETFs are designed to provide investors with exposure to commodity-related markets and/or assets. For example, a precious metals fund may hold physical bullion, while another index fund may track the price of natural gas, or own shares of companies that produce energy.

• Derivative-based exposure: Uses futures contracts where value is tied to a commodity. The ETF's performance can be affected by futures markets as well as changes in spot price.

• Equity-based exposure: The fund owns shares of different companies involved in the production or processing of a commodity. For example, a mining ETF may hold shares of several different mining companies rather than the actual metal. This means that factors like operating costs, management decisions, productivity, debt, regulatory issues, and geopolitical uncertainty can all affect share price.

How commodity ETFs obtain exposure

How an ETF is structured will determine how investors gain exposure to different commodities:

Physical holdings

Some commodity ETFs hold physical commodities, like precious metals. A physical commodity ETF involves arrangements that include custodians who keep the physical assets safe during storage, and insurance. Of course, these arrangements come at a cost, which may be reflected in the fund's expenses or how closely the value of the commodity is tracked.

Futures contracts and derivatives

Other commodity ETFs use futures contracts instead of holding commodities like wheat in physical storage. Futures trading involves purchasing or selling an underlying asset at a predetermined price at a future date. When the agreement is signed, the investor does not acquire asset ownership. Rather, they agree on a price for delivery or settlement at a later date, regardless of future market fluctuations. The contract also specifies the terms and a future delivery date for the assets.

Holding a contract until settlement does not happen in every deal, nor does it have to. For example, many futures positions are closed before the expiration date arrives. In the case of a futures-based commodity ETF, this typically happens on an ongoing, scheduled basis: as each contract nears expiration, the fund replaces it with a later-dated contract, a process known as rolling. Rolling is a routine and recurring part of how these ETFs operate, not an occasional adjustment.

The relationship between futures prices and the current spot price can also affect results. Contango happens when the futures prices are higher than the spot price, while backwardation occurs in reverse, when the futures price is lower than the spot price.

Commodity-producing equities

Some ETFs invest in companies directly involved in mining, energy production, agricultural commodities, and other commodity-related sectors. These funds are therefore connected to the market itself, not direct ownership of the commodities produced. For example, the share price of a mining company may be influenced by the price of the metals it produces, but it can also be affected by labour issues, debts, management decisions, production costs, and other external factors.

Commodity indexes and baskets

Commodity ETFs may provide broader exposure to several different commodities. While the exact structure and mix will depend on the individual ETF, it could include physical ownership and shares of a company. It may also focus heavily on a single sector, or provide more diversification among different industries.

Common types of commodity ETFs

There are numerous types of commodity ETFs Canadian investors may consider:

Precious-metals ETFs

Precious metals ETFs can provide exposure to silver, gold, platinum, or companies involved in producing these metals. While a physical gold ETF is connected to the value of the underlying gold itself, a gold mining ETF owns shares of a business, which can be impacted by corporate, operating, and geopolitical factors.

Energy ETFs

Energy ETFs may provide exposure to crude oil, natural gas, energy commodity indexes, or, again, companies involved in energy production. Structure is often noted when funds use futures contracts, as changes in futures curves (future prices relative to different expiry dates) can affect results when spot prices move differently than anticipated.

Agriculture ETFs

Agricultural commodities ETFs can provide exposure to products like grains, coffee, livestock, sugar, or seed oils. Agricultural markets can be influenced by factors like production, weather, transportation, changes in consumption, inventory, geopolitics, and more.

Industrial-metals ETFs

Industrial metal ETFs focus on commodities like copper or broader metal baskets used in manufacturing and infrastructure sectors. Prices can be affected by inventory, production levels, changes in demand, and more.

Broad commodity ETFs

Broad commodity ETFs combine several different commodity categories into a single index. Diversification will depend on how the index is structured. For example, one index may heavily focus on energy production, while another may focus on both precious metals and energy. That doesn't mean these commodities are evenly distributed, however, which means exposure to individual commodities can vary significantly between indexes.

Potential benefits and risks of commodity ETFs

Commodity ETFs provide exposure to commodity markets and assets. But the structures and mechanics of each ETF come with their own possible benefits and risks:

Potential reasons investors consider commodity ETFs

• Access to commodity exposure: ETFs can provide exposure to commodities without direct ownership of the physical resource.

• Exchange-based trading: ETFs are bought and sold on stock exchanges, similar to other asset classes.

• Different levels of exposure: Depending on the fund, exposure may come from physical commodities, futures contracts, commodity indexes, or commodity-producing companies.

• Operational convenience: A commodity ETF can provide exposure without the need to buy, store, insure, or sell the physical commodity itself.

Note: Commodity exposure can vary depending on the asset class, fund, structure, and time horizon.

Risks and limitations

• Commodity-price volatility: Commodity prices can raise and fall, affecting the value of the ETF.

• Tracking differences: ETFs may not move in line with the commodity or index they follow.

• Futures roll costs: ETFs that use futures contracts may be affected when expiring contracts are replaced with later expiration dates.

• Contango and backwardation: The relationship between futures prices and the current spot price can affect results.

• Management fees: ETFs tend to have operating costs that may reduce returns over time.

• Currency risk:Canadian dollar results can differ from U.S. dollar movements, which can increase or reduce returns depending on the direction of the exchange rate.

• Bid-ask spreads:The difference between bid price and ask price can result in potential

  trading costs.

• Concentration risk: When a fund focuses on a single commodity or sector, it offers less diversification, which means the fund's value is more sensitive to price swings in that single commodity or sector.

• Leverage: Some commodity products use leverage, which can increase losses and gains.

• Company risks: ETFs that hold mining, energy, or other companies are exposed to business-related risks that can impact price movements.

• Tax complexity: Tax treatment of commodity ETFs can vary depending on the structure, distributions, and account type.

Note: Risks and costs vary by fund. Read the prospectus carefully.

Commodity ETFs compared with other forms of exposure

Commodity ETFs are only one way Canadian investors can gain exposure to commodity markets. Each comes with different types of exposures, and the main difference between these funds is what the investment actually owns or tracks.

Commodity ETFs versus physical commodities

Buying a physical commodity means owning the underlying asset itself. Gold bars and coins are examples of this. Physical ownership can involve costs and other things to consider that do not apply the same way to commodity ETFs, including:

• Physical storage of the asset.

• Insurance coverage needs.

• Transportation of assets from one location to another.

• Authentication for selling purposes.

• Dealer premiums that can add to costs.

On the other hand, a commodity ETF provides exposure through the assets held by the fund. For example, an ETF that's physically backed by gold may allow investors to hold gold through a custodial arrangement. The ETF comes with its own expenses and trading costs.

This means that the two types of investments can provide different results, even when they are connected to the same commodity.

Commodity ETFs versus commodity-producing stocks

A commodity ETF and a commodity-producing stock also provide different types of exposures. A commodity ETF, for example, may hold physical commodities, futures contracts, or other assets directly linked to commodity prices. A mining or energy stock, on the other hand, represents an ownership stake in a company.

This means that the company's share price can be affected by factors that go beyond the underlying commodity, including:

• Production costs

• Debt

• Labour

• Management decisions

• Production levels

• Government regulations

• Geopolitical uncertainty and conflict

For example, an increase in the price of a physical commodity won't necessarily mean the share price of a company producing that commodity will increase in the same way.

Commodity ETFs versus commodity mutual funds

Commodity ETFs and mutual funds are both pooled investment products. This means that money from multiple investors is combined and later invested according to the fund's objectives. A difference, however, between the two is how the funds are bought and sold.

ETFs trade on the stock exchange during regular business hours, where prices change throughout the day. Mutual funds, on the other hand, are bought and sold only once a day at a price based on the fund's net asset value (NAV) per share, which is calculated based on the rules of the fund once the stock exchange closes.

Management fees, investment goals, holdings, and other factors will vary between individual funds, as outlined in the prospectus.

Single-commodity versus broad commodity ETFs

A single-commodity ETF focuses on one commodity or one commodity market, like crude oil, gold, natural gas, or silver. On the other hand, a broad commodity ETF can provide a broad basket of exposure to several commodities. Exposure weights can be assigned differently than in indexes.

Factors commonly reviewed when researching a commodity ETF

Commodity ETFs have different structures. Canadian investors, therefore, often review the fund's official documents to clarify what the product holds and how it's designed to provide exposure.

Commonly reviewed information investors may consider includes:

• Investment goal: Outlines what the fund is designed to track or achieve.

• Exposure method: Shows whether the fund uses physical holdings, futures contracts, equities, or other structures.

• Underlying holdings: Identifies the asset class or securities held in the fund.

• Benchmark or index: Shows what the fund is designed to track.

• Management expense ratio: The fund's operating expenses, expressed as an annual percentage of the fund's assets

• Trading costs: Commissions and other transaction costs.

• Bid-ask spread: The difference between prices set by buyers and sellers.

• Currency: The currency the ETF trades in.

• Distributions: Whether income or other amounts are distributed to investors.

• Tracking history: Historical differences between the fund and its benchmark. Note: Past performance does not guarantee future results.

Possible considerations for Canadian investors

Canadian investors may encounter commodity ETFs on Canadian, U.S. or other global exchanges. The listing currency does not always determine the currency exposure of the underlying investment.

Considerations often reviewed by Canadian investors include:

• Trading currency: Canadian ETFs often trade in Canadian dollars, while U.S. ETFs will often trade in U.S. dollars

• Currency exposure: Changes in the Canadian dollar can affect the value of investments linked to commodities priced in USD.

• Currency hedging: Some ETFs use currency hedging, while others don't

• Tax treatment: Taxes depend on ETF structure, distributions, and account type.

• Registered accounts: Rules for TFSAs, RRSPs, FHSAs, and RESPs can differ.

Conclusion: commodity ETFs in Canada

Commodity ETFs provide exposure to commodity markets through exchange-traded funds (ETFs). Some hold physical commodities, while others use futures contracts, or hold shares in commodity-producing companies. The difference in index structure can affect costs, risks, and index returns.