Diversify your portfolio with commodity ETFs

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Alternative investments made simple.

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Commodities are the basic materials that help our economy run. Commodities include the crude oil that powers most of our vehicles and the natural gas and heating oil that keep our homes warm in the winter. Copper is the conduit that electrifies our buildings, silver is in solar panels, and gold is in your jewelry and electronics. Your breakfast may consist of a cup of coffee, a bowl of cereal, and a glass of orange juice. These products are all based on commodities, many of which are easily investable through commodity exchange-traded funds (ETFs).

There are numerous commodity ETFs. Some of the largest trade gold or crude oil, while others focus on certain segments, including agriculture, energy, and precious metals. Commodity ETFs can be a good way to diversify your portfolio as an alternative to stocks and bonds. They also can act as an inflation hedge. But commodities have their own fundamental drivers that affect prices, so investors need to know what they’re buying.

Commodity ETFs enable you to invest in natural resources through an index, various products, or futures contracts. Commodities can be broken into several segments:

Many commodity ETFs follow an index. An index can be broad based and include components of several types of commodities, or narrowly focused on a single commodity. Examples of broad-based indexes include:

Many commodity indexes track commodity futures markets. These indexes typically rebalance annually, and committees decide which commodities to include in the index and each asset’s weighting. Commodities such as crude oil often get the biggest weighting. Commodity ETFs that follow an index seek to track the return and won’t outperform the index.

Although most commodity ETFs follow an index, not all do. Some may follow a specific futures market, while others are designed to track the price of a certain commodity.

Investors who buy commodity ETFs do not own the physical asset. Owning commodity ETFs is a convenient way to get exposure to the price of a commodity without having to deal with the hassle of transportation, storage, and insurance costs associated with physical assets.

Some commodity ETFs hold shares of commodity-producing companies, such as Energy Select Sector SPDR Fund (XLE) or VanEck Gold Miners ETF (GDX). Although the companies’ value is affected by the price of the commodity they produce, they are considered equity ETFs, not pure commodity ETFs.

The top commodity ETFs as measured by assets under management (AUM) vary based on market conditions; commodity ETFs often see assets swell when prices are rising. These five types of commodity ETFs include some of the largest by AUM:

Many commodity investment vehicles are ETFs, but there are also a number of commodity exchange-traded notes (ETNs). ETNs are lesser known and often confused with ETFs, but they’re different. ETNs are unsecured debt (not backed by collateral) obligations issued by a financial institution, usually a bank. ETNs do not own any securities, and the value of the note is determined by the issuer. One of the biggest commodity ETNs is the JPMorgan Chase Alerian MLP Index ETN, which is focused on midstream energy producers.

Before you buy commodity ETFs, read up on the fundamental factors that influence each market. Natural resource investing isn’t like owning stocks and bonds. The factors that affect corn are different from those that affect crude oil or copper. It’s also critical to know how a given ETF is structured, since it may affect performance and taxes.

Type of index strategy. A basic commodity futures strategy owns the front-month contract (the agreement with the soonest expiration date), which allows the ETF to get exposure to the spot commodity price. This strategy often must roll from one contract to the next. Transaction costs add up quickly if the next month’s price is higher than the current month (a situation known as contango), since the ETF has to buy high and sell low. United States Natural Gas Fund LP (UNG) uses this strategy.

Some newer commodity ETFs, such as United States Copper Index Fund (CPER), use laddered investments, where the ETF owns a series of futures contract months that minimize such roll costs. Some commodity ETFs use an optimized strategy, using a rules-based process to choose which futures contracts they own that also reduce roll costs. The Invesco DB Commodity Index Tracking Fund (DBC) is one example.

Taxes. Commodity ETFs based on futures contracts are known as commodity pools. They issue a K-1 tax statement rather than a 1099. These tax documents often are not available in time to file your annual tax return, so you will likely need to file an extension. To sidestep the problems caused by K-1 tax forms, some fund issuers have launched commodity ETFs that aren’t commodity pools, which allows them to issue 1099s. Many put that information right in the name of the ETF, such as Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC).

Owners of precious metals ETFs that track the price of bullion, such as SPDR Gold Trust, are subject to unique taxation when they sell their ETFs. The Internal Revenue Service (IRS) considers precious metals collectibles, and investors who sell their ETFs at a profit are taxed at a maximum 28% rate. That’s significantly higher than the 15% maximum tax rate on most net capital gains.

If you’re looking to diversify your stock and bond holdings, commodity ETFs are one of the most liquid ways to access alternative investments. Research from asset manager Vanguard Group shows that commodities are a hedge against unexpected inflation, rising 6% to 9% for every 1% increase in unexpected inflation.

That suggests a small allocation to commodities can have an outsize benefit. But don’t go all in. Although commodities can be a good inflation hedge, these investments don’t produce income or pay dividends, so any gains are due to price appreciation. Most investment professionals suggest a total holding of 5% to 10%.