Posted May 10, 2021
By Sean Ring
Why You Should Generally Avoid Commodity ETFs Despite Inflation, Commodity Prices Rising
Happy Monday, Rudes!
I thought Id start the week out with a warning and an explanation rather than just a news rundown. It may save your bacon if youre looking at how to take advantage of the imminent inflation hike.
Inflation, Up. Commodities, Up. Lets do Commodity ETFs!
It makes total sense. You think, Inflation is happening. Lumber, copper, and coffee prices are going through the roof. But I dont know if Ive missed these rallies, or which ones will go up next, so I probably should buy a commodity ETF.
The thinking is sound. But for reasons Ill demonstrate in todays Rude, most commodity ETFs should be avoided like the plague.
What are ETFs?
Very briefly, to make sure were on the same page, Ill define ETFs.
ETFs are exchange-traded funds, which have all the characteristics of a mutual fund, except they trade on a stock exchange like any other security.
A good reason to invest using ETFs is that theyre cheap to own. They only charge around 0.20% per year, because ETFs arent actively managed. And they certainly dont charge an assets-under-management (AUM) fee or a performance fee like hedge funds do.
ETFs are a great addition to most investor portfolios, as you can cheaply buy the market.
That is, you can buy ETFs on the following things:
- Bonds
- Bitcoin
- Commodities
- Equities
- Money Markets
- Multi-Asset
- Precious Metals
- Real Estate
One Drunken Night in a Club
At my last banking job, I was at an offsite in Taipei. One evening, over a bottle of champagne at a dance club, I was talking to a managing director about how I thought oil was going to explode higher. I didnt want to buy futures - as a former futures broker I knew how risky that could be - so I was thinking of buying the USO (United States Oil Fund) instead.With a look of solemn despair and warning, he said, Never do that. You must understand how most of these commodity funds are structured. You know what happens when markets are in contango. The roll yield will kill you.Im going to parse out that warning for you. Its amazing how some side conversation on the ass-end of the world can save your portfolio.How are Commodity Funds Structured?
If youre intent on investing in commodity funds, this is the first place you must do a bit of homework. The question you must answer is this: Does this fund use the actual underlying asset to create the fund, or does it replicate ownership using futures contracts?If its using the actual asset, fine. You can proceed. (For example, GLD, the SPDR Gold Shares, is the largest physically-backed gold ETF in the world.)But if its using futures contracts, its a no-go. Let me tell you why.Lets very quickly define futures contracts. Futures are a standardized obligation to buy or sell a specified quantity of a standardized asset at a price agreed today for delivery in the future.For example, the WTI oil futures contract is an obligation to buy or sell 1,000 barrels of West Texas Intermediate oil at the price you agreed today (say, $64.90) for settlement in the month you bought or sold (say, May 2021).The issue with futures contracts is that you need to roll them. They just dont last that long. That is, they mature every month.For instance, before the May 2021 contract matures May 31, 2021, you need to roll into the June 2021 contract. Then before June 30, 2021, you need to roll into the July contract.This can get very expensive, not because of the commissions - which are minuscule nowadays - but because of the difference between what you can sell the May contract for and buy the June contract for.That leads us to two more important terms.Contango Isnt a Dance; Backwardation isnt Reversing Your Car
As Socrates stated almost 2,500 years ago, The beginning of wisdom is the definition of terms. And boy, does the financial world throw up some doozies! So lets get these two esoteric terms defined.Contango simply means the futures price of an asset is greater than the spot or cash price of the asset. Although a futures price is not a prediction, contango usually occurs when price rises are expected over time.



Alternatives to Futures-Based Commodity ETFs
Trading the Futures Themselves
First, you can trade the futures themselves, but they come with all sorts of risks. Not my first choice unless you have millions of dollars in the bank already. And youve got the kind of mentality that can handle daily losses.
Buying Commodity Company ETFs
But you can invest in the ETFs of companies whose main business is commodities. If you like gold, you can look at GDX or GDXJ. If you like oil and gas, you can look at XOP or IEO.
Please keep in mind that Im not recommending these ETFs. Im only giving you an idea of what you can do, given your view.
Buying the Commodity Companies Themselves - The Pure Play
If you prefer single stocks and think you have an edge, you can always buy the company stocks themselves. ETFs provide diversification while also giving you exposure to a sector. But if you think a single stock will do the job for you and are willing to take the risk, this is your play.
For oil, this may be Exxon (XOM) or Chevron (CVX).
For gold, this may be Barrick Gold (GOLD) or Franco Nevada (FNV).
Again, you must do your research when undertaking these kinds of investments.
Just remember, the first thing you must do is preserve your capital.
Well, thats all Ive got for now. I wish you an absolutely rocking week ahead!
All the best,
Sean

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