Why ETFs aren’t always great for investing in commodities

Why ETFs aren’t always great for investing in commodities

You may have noticed the lack of commodity ETFs on our platform. There is a reason for this! While many customers have asked us to add more commodity ETFs — and it’s something we’re actively considering — many commodity ETFs (actually Exchange Traded Commodities or ETCs) aren’t suitable for long-term investing.

Basically, there are three types of commodity ETFs/ETCs:

1. ETFs/ETCs that physically invest in a specific commodity such as gold

These “physical ETFs” are generally for precious metals, and we already have a range of them on our platform, covering silver, platinum and palladium as well as gold.

You can find them by selecting ‘Alternatives’ in the ETF search tool from your portfolio dashboard.

2. ETFs/ETCs that invest using futures contracts on an underlying commodity

Many commodities such as wheat, natural gas and crude oil are difficult to physically invest in, so ETFs will often invest via the futures market.

‘Futures’ are agreements to buy or sell something at a specific price on a date in the future.

However for technical reasons the price of commodity futures often differs from that of the underlying commodity (the ‘spot’ price). Commodity markets are often said to be in either ‘contango’ - where the futures price is higher than the spot price - or in ‘backwardation’, where the futures price is lower than the spot.

Under normal market conditions, it makes sense that prices of futures contracts increase the farther the maturity date since they may price in inflation expectations, supply and natural market conditions.

Contango, which is most common in commodities, is where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time.
Backwardation (the opposite to contango) is when the current price, or spot price, of an underlying asset is higher than prices trading in the futures market.

Unless the holder sells the futures contract before expiration, they must either buy or sell the underlying asset at the stated price.

3. ETFs/ETCs that use ‘swaps’ or other derivatives to track the performance of a broad commodity index.

It is also important to note that despite an ETF replicating the performance of an index via swaps, the index itself will also roll futures contracts which may not be an optimal investment strategy.

Commodities such as wheat, natural gas and crude oil are almost impossible for the average person or even an institution to get their hands on. That’s why many exchange-traded funds turn to the futures and derivatives market to get exposure to these commodities.

A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future.

Unless the holder sells the futures contract before expiration, they must either buy or sell the underlying asset at the stated price.

Futures contracts are financial contracts that obligate a buyer to purchase an underlying asset and a seller to sell an asset at a preset date in the future. A futures price is the price of an asset’s futures contract that matures and settles in the future.

Detailed Deep dive

For example, a December 2022 futures contract matures in December 2022. Futures contracts allow investors to lock in a price, by either buying or selling the underlying security or commodity. Futures have expiration dates and prices that derive from the underlying commodity. These contracts allow investors to take delivery of the underlying asset at maturity, or offset the contract with a trade. The net difference between the purchase and sale prices would be cash settled.

In the case of commodity ETFs and the index they track, the ETF issuer has no interest in the delivery of the underlying commodities therefore these are closed out before the expiration date and rolled forward as per the mandate of the ETF and the commodity index. This is the main factor which makes commodity ETFs not suitable for long-term investing.

Commodity markets are usually in one of two different states: contango or backwardation.

Contango, which is most common in commodities, is where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time.

Backwardation (the opposite to contango) is when the current price, or spot price, of an underlying asset is higher than prices trading in the futures market.

Backwardation vs. Contango

For example in contango, the price of the November futures contract is higher than October’s, which is higher than July’s and so on. Under normal market conditions, it makes sense that prices of futures contracts increase the farther the maturity date since they include investment costs such as carrying costs or storage costs for a commodity.

When futures prices are higher than current prices, there’s the expectation that the spot price will rise to converge with the futures price. For example, traders will sell or short futures contracts that have higher prices in the future and purchase at the lower spot prices. The result is more demand for the commodity driving the spot price higher. Over time, the spot price and the futures price converge.

A futures market can shift between contango and backwardation and remain in either state for a short or extended period.

Backwardation Example

For example, let’s say there was a crisis in the production of crude oil due to poor weather. As a result, the current supply of oil falls dramatically. Traders and businesses rush in and buy the oil, which pushes the spot price to $120 per barrel.

However, traders expect the weather issues to be temporary. As a result, the prices of futures contracts for the end of the year remain relatively unchanged, at $90 per barrel. The oil markets would be in backwardation.

Over the course of the next few months, the weather issues are resolved, and crude oil production and supplies get back to normal levels. Over time, the increased production pushes down spot prices to converge with the end-of-year futures contracts.

The futures market is typically in contango which means the rolling risk for the ETF will be negative. Resulting in that the commodity ETF will be selling lower-priced futures that are expiring and buying higher-priced futures. The cost of adding higher-priced futures reduces the returns to the investor and acts as a performance drag on the ETF, preventing it from accurately tracking the spot price of the commodity.

The reason why there is not a great amount of tracking error in these types of ETCs is because the index itself has been designed to roll over the commodity contracts.

Example 1

For reference the white line is the performance of the ETF (NGSP), the orange line is the performance of the benchmark the ETF tracks and the purple line is the rolling price of natural gas (the commodity the ETF aims to track).

Using a Natural Gas ETF traded on the LSE (WisdomTree Natural Gas, NGSP) as an example we can see that on a 3 month basis the ETF is up 25.14% and the Brent oil rolling contracts are up 20.15%. The effect of backwardation has advantaged a client by 4.99%.

On a 6 month basis the ETF is down -13.95% and the natural gas spot price is flat down -16.37%. The effect of backwardation has advantaged a client by 2.42%.

On a 1 Year basis the ETF is up 75.56% however the natural gas spot price has increased 83.89%. The effect of contango has disadvantaged a client by 8.33%.

After 3 years of being invested in this ETF a client would have returned a loss of -32.46% whereas the price of natural gas has actually increased 70.38%.

The example above is a prime case of why InvestEngine does not include products such as this in the platform. It is in our best interest to protect and educate clients when we see fit against the limitation of some of these ETF products.

Source: Investengine, Bloomberg & Investopedia

3 Month dates: 15/12/2021 to 15/03/2022
6 Month dates: 15/09/2021 to 15/03/2022
1 Year dates: 15/03/2021 to 15/03/2022
3 Year dates: 15/03/2018 to 15/03/2022

Date of Data: 15 March 2022

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