Understand What is a Commodity ETF – Features, Advantages, and Who Should Invest

Now, not all commodity-based ETFs are the same. Some track a physical commodity, such as gold, while others track futures contracts linked to it. 

Here’s a quick overview of some common types of commodity ETF:
 

The key features of commodity ETFs are listed below:

1. Traded like Stocks on the Exchange

   A commodity ETF is listed and traded on recognised stock exchanges (BSE/NSE), just like shares. This means you can buy or sell units during market hours at prevailing prices.
    

2. Backed by Physical Commodities

   Physical commodity-based ETFs are backed by the actual physical commodity whose price they track. For instance, a gold ETF holds physical gold bullion in a secure vault with a custodian bank. 

   But note that this feature also depends on the type of commodity-based ETF in question (futures-based ETFs don’t hold the physical commodity). 
    

3. Requires a Demat Account and Trading Account

   Commodity ETF units are held in dematerialised format. This means that to invest directly in a commodity-based ETF, you need a Demat account and a trading account. A Demat account is required to hold ETF units, while a trading account is needed to purchase and sell units on the stock exchange.

   However, you can invest in certain commodity ETFs indirectly through mutual funds - Gold ETF FoFs and Silver ETF FoFs- without a Demat account. 
    

4. Pricing Linked to the Commodity’s Market Value 

   A commodity ETF tracks the price of the physical commodity or a commodity index. This means the ETF's price depends on the market price of the underlying commodity it invests in. So, for instance, if you invest in a gold ETF, the ETF’s NAV will track the price of gold in the Indian market and change as this price changes.

   But do note that commodity ETFs have tracking errors. So minor variations may occur.
    

5. Eliminates Storage and Purity Concerns

   Commodity-based ETFs help investors gain exposure to different commodities like gold, silver, oil, and agricultural products without storage and purity concerns. When you purchase physical-based commodity ETFs like a silver ETF, you don’t have to worry about theft, storage risk, or purity because the ETF holds the commodity on your behalf.

So, why should you consider investing in commodity ETFs? What benefits do they offer? Well, they have several advantages and a few of them are listed below:
 

Portfolio Diversification

One key benefit of investing in commodity ETFs is portfolio diversification. Commodities such as gold and silver typically have low correlation with equities. So, adding a commodity ETF (like a gold ETF or silver ETF) may help spread risk and cushion your portfolio against market swings during periods of volatility.
 

Ease of Access

Investing in physical commodities can be difficult. Figuring out issues like storage, purity, and safety can complicate the process. But commodity-based ETFs make it easy. These ETFs assess the purity of the commodity and are responsible for its safe storage. Moreover, since commodity ETFs are stored in Demat format, you don’t have to worry about storage either.
 

Simple Liquidity

Commodity-based ETFs trade on the stock exchange just like regular equity shares. This means you can easily buy or sell them during market hours. So, if you need access to your capital on short notice, you can sell your gold ETF or silver ETF units and redeem them. The proceeds are typically credited in T+1 business day. 
 

Can Act as a Hedge Against Inflation 

Certain commodities, such as gold, have historically served as a hedge against inflation. By investing in gold through gold ETFs, you can add a protective hedge to your portfolio against rising inflationary pressures, that too without storage or purity concerns. 
 

Assured Transparency and Regulation

Commodity-based ETFs in India are regulated by the Indian market regulator, SEBI. They have to adhere to SEBI’s regulatory framework, which protects investors' interests. Moreover, ETFs are also required to publish prices, historical performance, and portfolio composition data, which ensures transparency and makes it easier for investors to make informed decisions.

While commodity ETFs offer many benefits, they also carry certain risks:
 

Price Volatility

Commodity prices can fluctuate due to global economic factors, currency movements, inflation expectations, and geopolitical events. These price swings can be significant, impacting the price of commodity ETFs and their returns. 
 

No Income Generation Prospect

Commodity ETFs don’t generate any income in the form of dividends or interest. So, the returns depend entirely on the price appreciation.
 

There May Be Tracking Errors

Commodity ETFs aim to track the price of a commodity in the market, but also have tracking errors. It is important to research ETFs thoroughly because high tracking error can lead to greater deviations from expected returns. Moreover, higher management fees and expenses can also affect returns.
 

May Involve Complexity

Certain types of commodity-based ETFs, like futures-based ETFs, may be more complex to understand than others. For instance, futures-based ETFs don’t always match the spot price of the underlying commodity. These commodity ETFs may even face losses due to negative roll yield in contango markets. 

A commodity ETF may be suitable for investors who:

• Want to diversify beyond equity and debt

• Seek exposure to gold or silver without physical ownership

• Have a medium-to-long-term investment horizon

• Want to build an inflation hedge

• Understand commodity price cycles

• Prefer exchange-traded instruments
   

However, commodity ETFs may not be suitable for:

• Investors seeking regular income

• Those with short-term investment horizons

• Investors who are uncomfortable with price volatility

There are two primary ways to invest in a commodity ETF.

1. Direct Investment via Demat Account

   • Open a Demat and trading account

   • Search for the desired commodity ETF

   • Place a buy order during market hours
      

2. Through ETF Fund of Funds (FoFs)

   If you do not have a demat account, you can invest in commodity-based ETFs through mutual funds as well. The two most common and popular commodity ETF FoF options are:

   • Gold ETF FOF: A type of open-ended mutual fund scheme that invests in gold ETF units, which, in turn, hold physical gold of 99.5% purity.

   • Silver ETF FOF: A type of open-ended mutual fund scheme that invests in silver ETF units, which, in turn, hold physical silver of 99.9% purity.
      

You can invest in gold ETF FoFs and silver ETF FoFs through your mutual fund investment platform. Schemes offer both SIP and lump-sum investment options. But note that the investor must pay both ETF expenses and mutual fund management costs when investing in ETFs through mutual funds.

To sum up, commodity ETFs offer a simple way to invest in assets like gold and silver without physically owning them. This ensures freedom from safety worries, purity concerns, and storage issues. Moreover, since ETFs are passively managed, their expense ratios can be lower. 

That said, commodity-based ETFs can be volatile and do not generate regular income. They are generally better suited as a diversification tool within your portfolio rather than a primary investment. Always remember that your allocation depends on your goals, risk tolerance, and overall strategy.

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