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How Do Commodity ETFs Work?

This article was originally published on ETFTrends.com.

Commodities like agricultural goods and precious metals offer investors an alternative to divest their holdings. Often times, commodities march to the beat of their own drum compared to the broad market.

Because of this negative correlation, large downturns in the broad market may not affect commodities. Investors can participate in the commodities market by trading the actual commodity or their futures contracts.

An easier way for investors to participate in commodities is through a commodity exchange-traded fund (ETF). Investing through an ETF will allow investors to reap benefits, such as tax efficiency.

But exactly how do commodity ETFs work?

How Assets Are Held

Commodities come in a variety of options. Each commodity has its own nuances with respect to how their markets react to certain conditions affecting their respective industry.

Examples of Commodities

  • Precious Metals : gold, silver, platinum, palladium, and copper
  • Livestock : pork bellies and cattle
  • Agricultural : corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar
  • Energy : oil, natural gas and gasoline

As mentioned, commodity ETFs can hold the actual assets and place them in a physical storage area. Other ETFs prefer to trade the contracts tied to the commodities, track a commodity index or a combination thereof.

How an Investor Owns the Commodities

An investor in a commodity ETF does not typically own the actual commodity itself. Instead, an investor can own the contracts backed by the commodity.

The performance of the commodity will determine the value of the contract at the time it is bought and sold. ETFs investing in commodities typically use leverage, which is borrowed capital.

By using leverage, the commodity ETF has excess cash to invest in risk-free assets like Treasury bills as a hedge against the contracts. This protects the fund and its investors in the event of a downturn in that respective commodity market.

How Commodity ETFs Perform

The commodity ETF will typically create its own benchmark index to track the performance of the fund. Depending on the ETF, these commodities can track precious metals, energy or whatever commodity comprises the fund focus.

The performance of that proprietary index created by the fund will determine its performance. Since the performance is tied to an index, one thing to take note of is that tracking error could result in a commodity ETF--the price difference between an investment and that of the index.

Examples of Commodity ETFs :

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