Clients with an interest in commodities may have found themselves with restricted options due to the special features of this asset class. Now, however, with the availability of exchange-traded funds (ETFs), investing in commodities has become much easier.

The special considerations that arise when investing in commodities relate to their physical nature and the associated costs: shipping, storing and distributing things like crude oil or coffee, for instance, must be carried out by specialists, notes Kevin Gopaul, senior vice president and chief investment officer with BMO Global Asset Management Inc. in Toronto.

This physical nature also makes commodities more volatile as investments, since their price depends on supply and demand, which can be as unpredictable as world weather or political crisis in remote regions. As a result, prices can move quickly in either direction, which is why clients who are not familiar with commodity investing may find that an ETF that invests in a broad range of commodities, rather than a specific one, is the best option. These broad-based commodity ETFs typically have some risk controls built into them, based on allocations that spread the risk among the various commodities held in the ETF.

Although investing in commodity ETFs can be rewarding, it also tends to be challenging. Says Mary Ann Wiley, managing director and head of iShares Canada, a division of BlackRock Asset Management Canada Ltd. in Toronto: “Commodities should always play the role of a diversifier within a portfolio but should never make up a major component of an asset allocation.” However, she adds, commodities can be a useful tool to hedge against inflation, since their prices tend to rise when economic activity is stronger.

Jaime Purvis is executive vice president, national accounts, with Horizons ETFs Management (Canada) Inc. in Toronto, which is the largest provider of commodity ETFs in Canada. He says investors can benefit from strong price gains in commodities if they time their investments with an eye on how the stock market is performing. Says Purvis: “Most commodities tend to have high levels of non-correlation to both stocks and bonds. Holding them over a longer period of time tends to reduce the overall risk of a portfolio, since commodity prices have historically delivered different return trajectories than stocks or bonds.”

It’s also important to understand the fundamentals of how these types of ETFs are structure. There are two main types of ETFs, Wiley explains. There are those that hold physical commodities such as gold and silver, which can be stored in a secure vault. An example is Claymore Gold Bullion ETF and iShares Silver Bullion ETF. The other main type uses futures contracts to provide exposure to, but not ownership of, commodities that are impractical to store.

Purvis advises that there are also broad-based commodities ETFs, such as Horizons Auspice Broad Commodity Index ETF (HBR), which provide exposure to a broad range of commodity futures contracts. HBR invests in 12 different commodity futures contracts, which Purvis says is generally a lower risk and more diversified route for investors who wish to have access to commodities futures.

But Wiley advises that although physical commodity ETFs have more in common with stock ETFs than do futures ETFs because they directly track the price of, for instance, a metal, the returns on futures-based commodity ETFs are affected by many factors beyond price changes of the commodity. As a result, they are mainly used by professional portfolio managers, she says.

Purvis echoes that view. Many investors, he says, may not understand the risk associated with investing in futures contracts. He says that, when futures contracts of different terms are purchased — the most common being one-month futures — another contract has to be purchased upon the expiration of the first term.

“The process of buying the next contract is commonly referred to as the ‘contract roll’ and often more has to be paid for the next contract than the current contract,” Purvis explains. “This premium to roll into the next contract is referred to as ‘contango’, and so, in order to generate a positive total return in commodity futures investing, the market value of the futures contract has to increase more than the price of contango,” Purvis explains. Most of the cost of contango is related to the cost of storage for the commodities, which is a highly specialized system that requires extensive infrastructure. “Therefore, in a flat commodity market or a market with steepening contango, even if the market value of the commodities doesn’t change much, investors can still lose money on the investment because of the cost of contango, similar to how you usually have to cover the spread to win money on a football game,” advises Purvis.

On the flip side, there is an environment known as “backwardation” that can occur, which means that it can cost less to roll into new commodities contracts. While less common, this type of environment can occur in markets where demand for a commodity outpaces supply. In this environment, the investor can actually make money by rolling into the next contract, because they are paid a premium by the seller of the futures contract.

The last couple of years have not been a good time to be a commodity investor. “This is the only time in the last 20 years that the Dow Jones UBS Commodity Index has had three negative years in a row, suggesting that on a historical basis, commodities have compelling valuations,” says Purvis.

Management fees for commodity ETFs tend to be a little more expensive than traditional index ETFs due to the cost of trading commodities. Wiley says fees can range from 50 to 80 basis points but can be higher for specialized products that use leverage.

This is part two of a three-part web-exclusive special feature accompanying Investment Executive’s ETF Guide for Financial Advisors.