What You Should Know About Commodity ETFs

Commodity exchange traded funds (ETFs) have been enjoying a good run in the past year. But some ETFs haven’t been performing as well as their underlying commodities.

For most precious metals ETFs, the ETF will likely hold the physical commodity, but in many cases, a commodity ETF just holds future contracts or notes redeemable by a bank, remarks Kurt Brouwer for MarketWatch. By investing in futures contracts and other so-called derivatives, commodity ETFs may diverge from the actual commodity they are tracking.

For example, United States Natural Gas (UNG: 10.00 0.00 0.00%) plummeted around 50% in 2009 while natural gas prices only dropped around 12%. PowerShares DB Oil (DBO: 24.70 0.00 0.00%) has gained 16% since its inception in 2007, but oil prices have jumped about 40%.

The world of commodity ETFs was shaken as regulators talked about imposing position limits on the funds, according to The Motley Fool. Commodity ETF traders suspected that some may have been exploiting the funds’ predictability of always investing in the next month’s futures contracts in which the traders would push up contract prices just before funds “roll-over” them.

Commodities are still a good way to diversify an otherwise bland portfolio, but before you invest, assess your risk tolerance and act accordingly:

• If you don’t mind taking risks, narrowly focused commodity funds can give you more pure exposure to a particular commodity. With that single-commodity exposure comes more potential for volatility, though.
• If you want more safety, check out broad commodity funds that give you exposure to a diversified basket of commodities. The downside is that you won’t fully capitalize if any one commodity is performing particularly well.
• Utilize a strategy when investing in commodities. A simple one we suggest is trend following, which you can read about here.

• iShares GSCI Commodity Indexed Trust (NYSEArca: GSG)
• PowerShares DB Commodity Index (NYSEArca: DBC)
• Greenhaven Continuous Commodity (NYSEArca: GCC)
• iPath Dow Jones-AIG Commodity Index Fund ETN (NYSEArca: DJP)
• PowerShares DB Agricultural Fund (NYSEArca: DBA)
• Market Vectors RVE Hard Assets Producers (NYSEArca: HAP)
• PowerShares DB Energy Fund (NYSEArca: DBE)
• PowerShares DB Base Metals (NYSEArca: DBB)
• ELEMENTS S&P CTI ETN (NYSEArca: LSC)