Commodity ETFs: Futures or Physically Backed?

Two of the most common types of commodity exchange traded funds (ETFs) are futures-based and physically-backed. But are you well-acquainted with how they operate?

Futures are a promise to buy or sell a commodity for a set price on a date that’s in the near future. None of the ETFs that hold futures contracts claim to track the spot price of their respective commodities.  

The majority of these funds buy the near-month contract, selling it before expiration and buying the next month’s contract, and so on. If the price of the next month’s contract is higher than the current month’s, it’s a situation called contango, and it could cost you money when the contracts are rolled over. A negative roll yield (contango) could cause the net asset value (NAV) of a fund to deviate even further from the spot price of its underlying commodity. The opposite situation is backwardation.  

One way to mitigate the effects of contango is to look for ETFs that hold contracts throughout the year. There are just two such funds now: United States 12-Month Oil (NYSE: USL) and United States 12-Month Natural Gas (NYSE: UNL).

The purpose of a 12-month strategy will help protect futures investors from the problem of contango. Two weeks before the expiration of the nearest-month contract, the fund will roll forward another month, picking up the then-12-months-out contract.

Other examples of futures-based ETFs include: United States Natural Gas (NYSE: UNG), PowerShares DB Gold (NYSE: DGL) and iShares S&P GSCI Commodity-Indexed Trust (NYSE: GSG). 

Physically-backed commodity ETFs, on the other hand, are just as the name implies: each share is backed by a physical product. Right now, physically backed ETFs only give exposure to precious metals. You won’t find an ETF backed by barrels of oil or livestock. 

Physically backed ETFs have a special appeal to smaller investors who either lack the space for storage, or the inclination to hunt down and pay for storage themselves. In ETFs backed by physical metals, all you need to do is show up and buy a share. The rest is taken care of for you. 

These ETFs tend to correlate more closely to the spot price than commodity funds that hold equities or futures. The taxes are a bit different, too: profits in bullion-based ETFs are taxed at 28% (but consult your personal tax professional for specific advice). 

Physically backed commodity ETFs also enjoy the other benefits of ETFs, including cost-efficiency, tax efficiency and transparency (the bullion holdings in these funds are subject to regular audits and the results are posted on the ETF provider’s website).

• SPDR Gold Trust (NYSE: GLD)
• ETFS Physical Platinum (NYSE: PPLT)
• iShare COMEX Gold Trust (NYSE: IAU)
• ETFS Physical Palladium (NYSE: PALL)
• iShares Silver Trust (NYSE: SLV)
• ETFS Silver Shares (NYSE: SIVR)
• ETFS Gold Shares (NYSE: SGOL)

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