With the growing array of exchange-traded funds (ETFs) available to Australian investors, there are now even greater opportunities to diversify your portfolio into exotic areas like commodities. In recent months, for example, several commodity-linked ETFs have been launched on the market covering oil, gold, agricultural prices and a broader commodities index.
One issues investors to be remain aware of, however, is that some of these ETFs may not track their respective commodity markets in ways one might generally anticipate. In recent years, some investors in the US – where commodity ETFs have been around a lot longer – have been caught out by this.
Watch what you’re tracking
It’s not true, for example, that the crude oil ETF launched by BetaShares (ASX:OOO) tracks the spot price of oil. Nor it is true that the BetaShares agricultural ETF (ASX:QAG) tracks a weighted average spot price of corn, wheat, soybeans and sugar.
This is because these ETFs don’t invest in psychical commodities holdings but rather buy future contracts related to the price of oil and food, respectively.
An exception is the gold ETF. Storing gold is relatively cheap and easy – indeed much of the world’s investment gold stock simply stays in a vault and investors merely swap its ownership with pieces of paper.
But in the case of commodities like oil and food, storage is costly and ETF providers instead gain exposure to price changes by investing in futures contracts and then selling these contracts as they near maturity in order to buy new ones with a longer maturity date. This is known as contract ‘rolling’. In this way, these ETFs gain exposure to changes in contract future prices for their relevant commodity without ever needing to take physical delivery of the product.
Negative roll yield
So far so good, but here’s the thing: where the commodities’ futures price – say the price of oil in six months’ time – is higher than the current spot price, investors holding and rolling these contracts over will suffer what is called ‘negative roll yield’ as they will have to sell their current futures contract near the spot price and buy a more expensive futures contract.
All else constant, it means when the futures market is in ‘contango’ – that is, the future’s price is generally higher than the spot price – the returns from these commodity ETFs will underperform the spot price over time.
By contrast, when the future’s price is generally below the spot price – known as ‘backwardation’, the ETF will outperform the spot price over time. That’s because investors in the futures contract will ease a positive roll yield when they swap their higher-priced near-to-maturity contract with a cheaper more distantly dated one.
All this sounds technical, but the main point to understand is that when the future price is above the spot price – as is often the case – then the commodity-based ETF will underperform the spot price. If both the spot and futures prices are rising over time, an investor will still make money, but they may be disappointed to find it wasn’t as much as was implied by the rise in the spot price alone.
Example
As an example, world oil prices effectively doubled in the three years ended in March – from around US $50 a barrel to US$100. But the underlying index tracked by the BetaShares crude oil ETF – which also includes a currency hedge to offset changes in the Aussie dollar versus the greenback – only rose by 10%.
The difference in spot oil prices and the GSCI Crude Oil excess return index – tracked by the BetaShares ETF – is readily apparent in the chart below.
It pays to know what you’re investing in. And as the saying goes: buyer beware.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
