Avoid currency risk

What’s more, the latest ETF commodity offerings from innovative local provider BetaShares also hedge away currency risk – meaning Australian investors don’t need to worry about reduced returns from investing in US dollar-denominated commodity indices should the Australian dollar keep rising.

As seen in the table below, Betashares offers three Aussie-dollar hedged commodity ETFs covering gold, crude oil and agricultural prices. The latter ETF tracks an index with exposure to corn, wheat, soybean and sugar prices.

The steep rise of the Australian dollar in recent years has reduced the Aussie-dollar returns for unhedged Australian investors in foreign markets. But with a currency hedge, the impact of our currency’s movements on offshore investment returns is largely nullified – giving investors purer exposure to world commodity price trends.

At present, hedging also provides an added bonus; with Australian interest rates now considerably higher than those in the United States, the currency hedge – effectively borrowing US dollars to buy Australian dollars – provides a modest positive yield return, on top of any return generated from the underlying movement in the commodity price benchmark.

Before you buy

That said, there are a few other considerations investors need to be wary of before ploughing into this relatively new area of the market.

First, due to the cost and impracticability of physical storage, some commodity ETFs – such as for oil and agriculture above – usually gain price exposure by investing in futures contracts rather than physical holdings of the commodities they track. Because of this, they are known as ‘synthetic’ ETFs.

When future prices trade at a significant premium to spot prices, known as ‘contango’, the result is that the price performance of synthetic ETFs can underperform spot prices over time. This is because futures contracts lose value relative to the spot price as they approach expiry and need to be sold or ‘rolled’ into new higher priced futures contracts over time.

By the same token, however, synthetic ETFs can outperform spot prices when the futures market trades at a discount to spot prices, known as ‘backwardation’.

In recent years, for example, many US investors have complained that the oil price ETFs they were holding underperformed relative to the rise in spot oil prices – which, unbeknownst to many, was due to contango in the futures market.

Another often stated concern with synthetic ETFs is counter party risk – or the risk the future contract held could be rendered worthless by the failure of the counter party to the agreement. In the case of the BetaShares’ oil and agricultural ETFs at least, funds are invested in cash that is held in a separate account by a third-party custodian – the value of which is adjusted daily in line with changes in future prices. So even if a particular counter party loses the ability to provide future contract returns at some point, the ETF’s capital value is still preserved in the cash account and an arrangement could then be made to deal with another counter party thereafter.

Note: the BetaShares’ gold ETF, moreover, is backed by physical bullion, that is, it’s non-synthetic, meaning it’s performance will more closely match that of the gold spot price, and it doesn’t face the counter party risks associated with derivative contracts.

Commodity ETFs expand the investment choices for local investors. But while at face value they seem relatively easy in concept to understand, it pays to ‘look beneath the hood’ into how they are structured so as to fully understand their likely risks and returns.

Would you like to know more about ETFs? Read, What’s an exchange traded fund? and How risky is your ETF?