Commodity ETFs use futures contracts, which can cause some complications when it comes to returns.
Alongside shares, bonds and property, commodities are one of the most popular asset classes for investors. Generally, the expectation is that commodities will provide some form of diversification. Historically, it has been relatively hard for private investors to gain direct access to commodities. However, thanks to the exchange-traded fund (ETF) revolution, gaining exposure has become easier than ever.
When it comes to passively investing in commodities, investors have two main options. First, an ETF that tracks a broad basket of commodities. Second, a fund that tracks the price of a single commodity. These funds are usually what are known as exchange-traded commodities (ETCs).
ETCs are similar to ETFs and often referred to colloquially as ETFs. Like ETFs they are listed on a stock exchange and traded throughout the day like shares. However, the two are technically different structures. The reason for the use of ETCs for single commodities is that under European regulations, ETFs are required to provide a minimum level of diversification. In practice, this means they cannot hold just one type of commodity.
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Hence, as a rule of thumb, ETFs are used for broad basket commodity exposure. These ETFs will also use futures contracts to gain exposure, meaning the investor does not “physically” own the underlying assets.
Instead, they own a futures contract. Such contracts allow investors to gain access to the returns of an asset class such as commodities without the need to hold the assets physically.
When a futures contract “expires” the holder is delivered the commodity in question. The ETF will sell these contracts before expiration date and buy new ones.
This can cause some complications in the returns for the investor, as explained below. First, however, we offer an outline of the major broad basket commodity indices.
Broad basket commodity ETFs
This is perhaps the simplest and most straightforward way to gain exposure to commodities. These ETFs will track an index made up of several different types of commodities, such as oil, industrial metals and precious metals, and sometimes livestock and agricultural products. To do this, the ETF will buy forward or futures contracts.
There are several commodity indices an investor can chose from. One of the most popular is the Bloomberg Commodity Index. This index tracks 23 different commodities. Commodities in the index are weighted by the economic significance of the commodities. However, each commodity is capped at 15% of the total index, while each commodity “segment” is capped at 33% to ensure the index remains diversified.
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One way to track this index is through the L&G Bloomberg Commodity ETF (LSE:BCOG), which has an annual charge of just 0.16%.
Another option is the Refinitiv/CoreCommodity CRB Index. Readers may also know this index under its older name, the Thomson Reuters/CoreCommodity CRB Index. This index has 19 different commodities, making it somewhat less diversified that other commodity indices. Its methodology is also more complex, with its weightings based on a variety of interacting factors, including liquidity, the economic importance of the commodity, and the performance correlation of different commodity sectors.
This can be tracked using the Lyxor Cmdts Rfntv/CrCmd CRB TR ETFAcc€ USD (LSE:CRBL). It has an ongoing charge of 0.35%.
Another option is the Rogers International Commodity Index. This index has a total of 38 commodities. Weightings are determined by global consumption of each commodity, as well as liquidity. On interactive investor, this index can be accessed using the Market Access Rogers Intl Cmdty ETF GBP (LSE:RICI). At 0.6%, it is more expensive than the other broad basket index options.
Different weightings of the broad basket ETFs
With different numbers of constituents and different weighting methodologies of the indices, investors in each ETF will get difference types of exposure and therefore different performance.
As of August 2021, the Bloomberg Commodity Index had a weighting of 36% towards energy, 28% towards agriculture, 15% towards industrial metals, 15% towards precious metals and 5.4% towards livestock.
This meant compared to the Refinitiv/CoreCommodity Index, it was slightly underweight energy, with the latter index having a 39% weighting towards energy. It was also underweight compared to the Rogers International index, which had just over 40% in energy.
Meanwhile, the Bloomberg index is more overweight metals. Its combined weighting of both industrial and precious metals is above 30%. The other two indices do not separate out their metals into industrial or precious categories. The overall metals exposure of the Refinitiv/CoreCommodity Index is 20%, while the Rogers International index has just over 25%.
Within the metals category, investors in the Bloomberg index will gain a much higher exposure to gold, which is comprised of 11.6%. The other two indices have around half that.
These weightings can, of course, change. The latest weightings can be found on the individual factsheets of the indices.
The enhanced commodity index
Another popular broad basket index is the Optimised Roll Commodity Total Return Index. In terms of weightings, it is the same as the Bloomberg Commodity Index. However, the key difference is that the specific futures contracts used to gain commodity exposure are chosen with the best, or optimal, return in mind.
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This makes it different from other commodity indices, which tend to invest in so-called front month contracts. As noted above, commodity ETFs will buy futures contracts. When these expire, they will need to buy replacement contracts. If a fund invests in front month contracts, it gains exposure to the nearest contract on the futures curve. That is, the one with the shortest maturity. This approach is designed give the maximum exposure to the spot price of the commodity. Each time the front month contracts nears expiration, the ETF will “roll” on to the next contract, which then becomes the new front month contract.
In contrast, the Optimised Roll Commodity Total Return Index aims to improve investor returns by taking a more flexible and dynamic approach. The index picks the contract on the futures curve that promises the best potential “roll yield”.
Contango and backwardation
To understand roll yield, the investor must first grasp the concepts of “contango” and “backwardation”. Futures contracts have expiration dates, meaning at a set date they expire. The price of the contract is determined by how close it is to expiration, known as its maturity. Typically, the longer away the contract is from its expiration, the more expensive it is. This is known as “contango”. However, at other times, longer-dated contracts can be cheaper than shorter-dated contracts, known as “backwardation”.
This gives rise to so-called roll yield. When an ETF’s futures contract expires, it must buy new ones to replace it. Whether the market is in contango or backwardation will determine the roll yield. When the curve is in contango, the roll yield will be negative as the investor will be “rolling up” the curve. This means they will be paying more to buy the new, slightly longer dated contract than they received from selling the old, shorter dated contract. This results in a loss for the investor i.e., negative roll yield.
Alternatively, when the curve is in backwardation, the roll yield will be positive as the investor will be “rolling down” the curve. They will get a higher price for their shorter dated, expiring contract than it will cost to buy the longer dated replacement. This results in a gain for the investor i.e. a, positive roll yield.
An “optimised roll” means that the index follows a strategy to maximise the positive roll yield and minimise the negative roll yield impact where possible. In contrast, a non-optimised commodity index will just buy the next shortest maturity contract when their current ones expire. Therefore, the index aims to outperform the Bloomberg Commodity Index over the long term.
Investors can access the optimised roll strategy by using the WisdomTree Enhanced Cmdty ETF GBP H Acc (LSE:WCOM), a member of interactive investor’s Super 60 list.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.