Understanding commodity ETFs

Commodity ETFs are an innovation that has opened up some of the oldest markets in the world to ordinary investors.

Commodities have long been considered a portfolio diversifier and inflation hedge, thanks to historically low equity market correlations and a value derived independently of any nation’s currency or economy.

Historically, burdensome trading and settlement aspects for physical commodities and futures contracts meant that commodity investing was the exclusive domain of institutional investors and professional traders. With the arrival of commodity Exchange-Traded Funds (ETFs), all that has changed.

Commodity ETFs are an innovation that has opened up some of the oldest markets in the world to ordinary investors. These products, like the commodities they track, come in all shapes and sizes and present their own distinct challenges. Over the past few years, there has been an explosion in the number of commodity ETFs providing investment exposure to metals, agricultural products and energy consumables such as oil and natural gas. The key to successfully including ETFs in a portfolio is understanding the nuances of how commodities are tracked and priced.

How ETFs track prices

Commodity ETFs are designed to track commodities in different ways. ETFs backed by physical commodities, such as SPDR Gold Shares (GLD-US), which tracks the price of gold, are relatively straightforward in that there are actual physical quantities of gold backing each ETF unit. However, with most other commodity ETFs, the underlying units are priced off commodity futures.

The most common question is: Why not just price ETF units off physical spot prices? The reason is that most physical commodities differ in quality, are often hard to store and are difficult to transport (and, thus, illiquid). As a result, all barrels of oil or bags of coffee, for example, are not fungible (that is, freely interchangeable).

Pricing off of futures solves this problem because futures contracts are liquid and standardized (meaning that they are fungible). In the case of commodity futures-backed ETFs, such as United States Oil Fund (USO-US), which tracks the price of crude oil, USO buys near-dated futures contracts that have the highest correlation to the oil spot price; events that affect the current oil price will have less of an effect on the price of oil further into the future. While futures-backed commodity ETFs track commodity spot prices closely, there are slight nuances that may affect returns.

The shape of the futures curve

In addition to looking at movements in the spot price, the shape of the commodity futures curve affects ETF returns.

As the date of a futures contract nears expiry, the price of the contract gradually inches towards the spot price. In order to avoid taking physical delivery, for example, each month USO must sell the current oil futures contract, and then reinvest the funds into a later-dated contract to maintain investment exposure. When this occurs, the reference price on the new contract can be reset higher than the spot price (contango, an upwards-sloping futures curve) or lower (the opposite, called backwardation), depending on the shape of the futures curve at the time.

All else being equal, in an upwards-sloping futures curve environment, the ETF will gradually lose some value as the price of the futures held by the ETF moves towards the lower spot price at expiry. In a downwards-sloping curve environment, the ETF will gain value as the price of the futures contract moves towards the higher spot price.

The futures curve is determined by several factors, including: market supply and demand, seasonality, interest rates and storage costs. There are many theories that try to explain the shape or structure of the oil futures curve, but there is no one theory that is able to explain the shape of the curve at all times.

ETF prices: All in the timing

Many investors have expressed concern over a perceived performance mismatch between official futures movements and commodity futures-backed Exchange-Traded Funds (ETFs). A lot of this can be explained by the different settlement times for futures markets and equity markets.

With most futures trading, an electronic trading market runs concurrently with futures pit trading. Here are some examples of how this timing can influence certain commodity prices:

Oil and gas futures: The pit trading session runs from 9 a.m. to 2:30 p.m. (EST), but electronic trading continues to affect the price of futures-backed ETFs after the futures pit closes. Therefore the settlement price for futures-backed energy ETFs at the end of the day reflects the price of commodities trading at 4 p.m. in the electronic market — not the earlier futures pit settlement price. According to ETF providers, the electronic trading liquidity of energy futures also starts to dry up around 3 p.m., when corresponding ETF bid-ask spreads tend to widen noticeably.
Gold futures: Pit trading occurs from 8:20 a.m. to 1:30 p.m., but, like energy futures, the day’s ETF settlement price reflects prices of commodities trading at 4 p.m. in the electronic market. Gold futures also experience the same kind of late-day diminishing of trading liquidity around 3 p.m.
Grains futures: There’s an added complication to grain futures commodity prices in that pit trading takes place between 10:30 a.m. and 2:15 p.m, while electronic trading of grain futures runs between 7 p.m. and 7 a.m., outside of equity market hours. This means bid and ask spreads for grain ETFs tend to widen between 9:30 a.m. and 10:30 a.m. and from 2:15 p.m. to 4 p.m. Therefore the closing price for grain ETFs at 4:00 p.m. merely reflects changes in investor sentiment occurring after the grain futures pit closes.

Investors are not always aware of these timing differences, and are often confused when the performance of the next day’s futures contract differs from the corresponding ETF. The futures pit has to catch up to the extra period of ETF trading from the previous day.

Investors looking for the best price execution will purchase ETFs during pit session hours; however, electronic liquidity is usually still reasonable right after the pit session ends.