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Commodity ETFs: How to Profit from Lower Risk Exposure
A common mistake made by many investors is to allow themselves to become intimidated by the world of commodities. Yes, it is true that investing in commodities can be risky, probably more so than stocks and definitely more so than buying bonds or mutual funds, but that doesn't mean commodities should be ignored altogether when constructing your portfolios. If nothing else, commodities are a great way to hedge your portfolio against the vagaries of inflation. After all, the major commodities, such as crude oil and gold are denominated in US dollars. Meaning that when their prices rise, the purchasing power of dollars is weakened.
Fortunately there's a way for astute investors to benefit from this scenario without incurring unnecessary risks.
Commodities ETFs Save The Day
As the popularity of the ETF (Exchange-Traded Fund) has surged in recent years, so has the number of commodity-centric ETFs. There are now hundreds of commodity ETFs available to investors. These offerings are ideal for investors seeking commodities exposure without the risk involved in playing the futures markets. Name a commodity and there's probably a corresponding ETF. Everything from crude oil to coffee to gold to forex futures has been rolled into an ETF.
So what's the advantage of owning shares in a commodity compared to the corresponding futures contract? As we've already highlighted, commodity ETFs significantly diminish your risk exposure. Commodities markets are notoriously volatile and it is possible to lose more than your initial investment on a commodities contract if you're not careful. Since commodities ETFs are just like other ETFs in that they trade like stocks, your risk is simply limited to the daily performance of the ETF.
What Makes Commodities ETF Different
If you're familiar with equity ETFs, you probably know that these funds hold a group of stocks that fit a certain criteria. For example, the SPDR S&P Retail ETF (XRT) holds only retail stocks. That's generally the point of equity ETFs: To give investors exposure to a variety of stocks in a single sector. On the other hand, commodities ETFs may hold the actual physical commodity the ETF is supposed to be tracking, futures contracts with varying dates for that commodity or a mixture of both.
If you follow the oil sector, you have heard of the United States Oil Fund ETF (USO). USO is designed to closely mirror the daily price action in West Texas Intermediate Light Sweet crude oil. USO invests in crude oil futures contracts, cash-settled options and forward oil contracts. However, it does not directly own physical oil.
Now if you're looking for a commodity ETF that actually holds the physical commodity, gold is the area you might want to look. Take the SPDR Gold Shares (GLD). GLD, which is designed to mirror the daily performance of gold prices, holds actual gold bullion. In fact, GLD has quickly become one of the largest holders of gold in the world. This ETF owns more gold than the central banks of many of the world's countries. GLD never sells its gold unless it needs to pay expenses related to operating the fund.
These are just two examples of how commodity ETFs are different from their peers and there is no empirical evidence to suggest that commodity ETFs that hold futures contracts outperform those that hold the physical asset or vice versa.
Commodities Have Long-Term Potential
One of the axioms that investors hear about quite frequently is investing for the long-term, especially as it pertains to stocks. Well, that certainly applies to commodities as well. Certainly, commodities have a penchant for wild price swings, and it's difficult for retail investors to purchase futures contracts that are more than a couple of months out, but history has show that despite the price swings, commodities typically return to their long-term averages.
This makes commodity ETFs all the more appealing because their ideal holding periods are often more favorable to investors that don't need to make a quick buck. Holding a commodity ETF for a year or more probably isn't ideal, but a holding period of say, several months doesn't enhance risk and can put the investor in position for some nice returns.
The Trend Is Your Friend With Commodities ETFs
That's another old investing adage that you've probably heard a million times, but being on the right side of the trend is always important, especially with commodities. Bullish commodity trends can last for extended periods and commodities don't need a bull market in stocks to have bull markets of their own. So make sure a positive trend is forming in the commodity you're considering before diving into its corresponding ETF.
And now is probably the time to consider commodity ETFs. With Uncle Sam hitting the printing presses to pump more dollars into the system, inflation could be just around the corner, so take out an insurance policy with some commodity ETFs.
