Navigating the Fine Print: What to Know Before Investing in Commodity ETFs

Before choosing a commodity ETF, you must be 100% clear about why you want it in your portfolio. Commodity ETFs can serve different roles, such as, they can be used to:

• Hedge inflation

• Add diversification

• Exploit short-term opportunities

Each purpose demands a different mindset and holding period. Now, after deciding on your purpose, make an evaluation based on the following factors:

1. Understand What the ETF Actually Holds

When you buy a commodities ETF, you must first know what sits behind it. Some ETFs own the real commodity, for example, gold or silver bars stored in a vault. These are called “physical ETFs”. 

Others do not hold the commodity itself. Instead, they use futures contracts, which are agreements to buy or sell the commodity at a later date. Let’s understand these two commodity ETF types in detail:

So, before you invest, check the “fund factsheet” to see whether the ETF is marked as:

• Physical

• Spot

• Futures-based

This single detail influences your return pattern and risk level.

2. Check How Easily You Can Enter or Exit the ETF

Before investing in a commodity ETF, make sure you can buy or sell units without facing pricing issues. This depends on liquidity, which reflects how active the ETF is in the market. If an ETF has low trading activity, even a small order can lead to major fluctuations in its price. 

The bid–ask spread is another signal. For those unaware, it represents the gap between:

• The price buyers offer and

• The price sellers want

A wide spread increases your trading cost because you pay more when buying and get less when selling. Thus, as an investor, you should review:

• Average daily trading volume

• Assets under management (AUM)

• The usual bid–ask spread on the exchange

Commodity ETFs with higher liquidity + narrower spreads may be preferred.

3. Assess The Stability of ETF’s Counterparties

Some commodity ETFs do not buy the real commodity! Instead, they use swaps or other financial agreements with external parties. These parties are called “counterparties,” who may promise, “We will give your ETF the same return as the commodity price.”

Let’s understand better through an example:

• Let’s say a precious metals exchange-traded fund does not hold gold or silver in its physical form.

• Instead, it has an agreement with another company that says, “If gold goes up 5%, we will pay you that 5%.”

• So the ETF depends on that company to honour the promise.

Now, if the counterparty company faces financial distress and cannot pay the ETF what it promised, the ETF may lose money even if the commodity price goes up. This is known as counterparty and credit risk.

To pick the right financial product, you should check as an investor

• Who are the companies the ETF is depending on?

• Are the agreements protected with collateral?

• Does the ETF hold assets separately in case a counterparty fails?

4. Study How “Futures Prices” May Change

If the ETF uses futures, you must understand how the futures market behaves. Note that futures expire, so the fund keeps replacing old contracts with new ones. This process is called “rolling”. 

Now, understand that the price of the new contract can be higher or lower than the old one. This leads to two unique market situations:

This gain or loss is known as “roll yield” and directly influences the returns of a commodity ETF. Okay, but how can I check it? You can study this by:

• Reviewing the ETF’s long-term performance versus the spot price +

• Reading the fund’s commentary on its roll strategy.

   

5. Check How Closely the ETF Follows the Commodity

“Tracking error” shows how accurately the ETF mirrors the price of the commodity it claims to follow. A perfect ETF (hypothetically) would rise and fall at the same rate as the commodity. However, in reality, ETFs lag or deviate due to:

• Fees (say expense ratio)

• Operational costs

• Futures roll impact

• Liquidity issues

Always remember that a high tracking error may signal that the ETF is not accurately capturing the movement of the underlying commodity. To judge this, you can look for “historical tracking error” from the ETF factsheet. 

Next, compare this error across 1-year, 3-year, 5-year & since inception periods. A commodity ETF with consistently low tracking error may be preferred.