In the 2015 movie about the financial crisis, “The Big Short,” Steve Carell’s character asks a fellow financial professional how he makes his money on Wall Street.
“Commodities,” the man says.
“Well, good luck with that,” Carell’s character says derisively.
[See: 9 Food-Focused ETFs to Feed Your Portfolio.]
Compared with stocks and bonds, tradable raw materials don’t get much respect. But experts say commodities should make up a small percentage of a portfolio because these assets behave differently from equities or fixed income, making them a good diversification tool.
“Every diversified portfolio should have exposure to commodities,” says Will Rhind, founder and CEO of GraniteShares, a new investment company offering commodity-based financial products.
But buying and storing natural gas or cattle isn’t exactly practical for most investors. And trading futures contracts directly is a complicated world and mainly the purview of sophisticated hedge funds or trading shops.
So mutual funds or exchange-traded funds have become popular ways for average investors to get exposure to the natural resources that are staples of everyday life, such as oil or agricultural products.
“The most easily accessible and convenient way for investors to own commodities are through funds,” says Christian Magoon, founder and CEO of Amplify ETFs. His company just launched Amplify YieldShares Oil-Hedged MLP Income ETF (ticker: AMLX).
But not all exchange-traded funds are created equal, and each has its benefits and drawbacks. Some ETFs buy shares of commodities producers while others buy futures contracts or buy and store the commodity itself. Because some commodities ETFs may require filing an additional tax form, consult a tax expert before adding these investments to a portfolio.
Equities. Funds that own commodities producers, such as the VanEck Vectors Gold Miners ETF ( GDX) or the FlexShares Morningstar Global Upstream Natural Resources Index Fund ( GUNR), have racked up billions in market capitalization.
A key advantage to owning the equities, if you hold them long enough, is that the gains can be taxed under long-term capital gains rules, says Jay Jacobs, director of research with Global X Management Co. But with futures trading, a portion of the gains are taxed under the higher short-term capital gains tax.
The stocks tend to have more leveraged exposure to a commodity, which means when the commodity goes up, the stock can rise by a larger percentage, Magoon says.
Jacobs gives the example of a theoretical silver miner, whose operating costs run to $15 per ounce of silver produced. If silver trades at $15, the miner makes no money. If the price goes to $16, the miner makes $1. But if the price jumps to $17, the miner’s profit has doubled even though silver didn’t appreciate anywhere near 100 percent.
But leverage is a two-way street. “That can work against you too if you find yourself in a bear market,” says Jacobs, whose company runs several commodities ETFs including the Global X Silver Miners ETF ( SIL).
The disadvantage of investing in commodities through equities is that investor sentiment can have a bigger influence on how the commodities companies trade than the value of their underlying commodities, Magoon says.
Also, companies could have poor management, Magoon says.
Other risks can include the politics of the countries where the companies do business, too much debt or depreciating assets, Rhind says.
“In general, it’s not a pure play,” Magoon says of the companies’ relationship to the price of the commodities they produce.
[See: Oil ETFs: 8 Ways to Invest in Black Gold.]
Futures contracts. Funds such as the United States Oil Fund ( USO) or the PowerShares DB Commodity Index Tracking Fund ( DBC) that invest in futures offer more direct exposure to commodities than those investing in company shares. Futures contracts are agreements to buy or sell commodities at a fixed price in the future.
These types of funds are a good way to make bets that a commodity will rise or fall in price, Rhind says.
Also, many of these funds don’t have much flexibility over which futures contracts they can own, Magoon says. Because futures contracts expire, this often means the fund must sell the contract that is closest to its settlement date and buy one further out that is more expensive.
But there are times when further-out futures are less expensive, and in those cases investors would gain, Rhind says.
There are also transaction costs associated with these funds because futures can cost more to trade than equities, Jacobs says.
Actual commodities. Magoon likes a third category of funds, which hold physical commodities, such as the SPDR Gold Trust ETF ( GLD) or the iShares Silver Trust ( SLV). These physically backed funds tend to do well tracking the spot price of the underlying commodity, he says. Plus, they don’t have to constantly roll out of expiring futures contracts, he notes.
[Read: Use Your Tax Return to Cut Next Year’s Tax Payment.]
But because some commodities spoil or take up a lot of space, physically backed funds are limited to precious metals, Magoon says.
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3 Ways to Invest in Commodities Funds originally appeared on usnews.com
