Before exchange traded funds (ETFs) covered the commodities space, a person had to either be part of a large institution or have an account in the commodities pits to gain exposure to price movements in the commodities market. Now, any average retail investor may trade in commodities with a click of a mouse.
 
Commodity ETFs provide exposure to the broader categories, such as agriculture, metals and energy, along with the many different single commodities found within the main categories. Most commodity-based ETFs gain exposure to their underlying commodities through three primary formats: physical, futures and equities.
 
Broad Commodity ETFs
To start off, broad commodity ETFs hold a basket of commodities and offer investors the chance to diversify into the commodities market. The main commodity indexes that these ETFs track are the Goldman Sachs Commodities Index (GSCI) and the Dow Jones-USB Commodity Index (DJ-USBCI). Commodity ETFs can also be broken down to other large areas like agriculture, metals and energy, as mentioned above.
 
However, the major drawback of broad commodity ETFs is that each commodity is lumped into one broad asset class, which would ignore the various fundamentals that affect the price movements of individual commodities.
 
Physically Backed ETFs
Currently, only precious metals ETFs are backed by the physical commodity because it is much easier to gather and store the precious metals bullions in a vault, as compared to other commodity assets. Each share of a physically backed ETF traded on an exchange represents a partial ownership of the precious metal bullion owned by the fund. The metal bars are safely secured in vaults in London or Zurich, depending on the precious metal ETF. Investing in physical commodity ETFs offers the exposure to the underlying commodity without the hassle and added costs of monitoring and storing the precious metals yourself.
 
It should be noted that if a physically backed ETF is held for more than a year, the ETF is taxed as a collectible. If the fund is held under a year, it is subject to capital gains taxes. Potential investors should still consult their tax experts.
 
Futures-Based ETFs
A majority of commodity ETFs deal with futures contracts traded on the commodities exchange. The futures contracts are usually settled or swapped for cash before the date of maturity to prevent the fund from taking actual physical delivery.
 
However, by settling contracts in cash, futures-based ETFs will come with a time component that could affect the ETF. For instance, when the front month contracts cost more than today's contracts, the futures contract is in contango, the opposite is called backwardation. If the underlying commodity's futures contracts are in contango, the ETF could lose money when the managers roll contracts.
 
Some futures-based ETFs, though, utilize strategies that try to mitigate the effects of contango by holding positions in markets under backwardation. For example, "optimum yield" futures-based indexes try to include contracts that mature in the month with the highest "implied roll yield" to minimize the effects of contango and maximize the effects of backwardation as a way to generate optimal returns.
 
It should be noted that futures-based ETFs are taxed as partnerships--the costs of the fund are spread among all of the owners at the end of the tax year, regardless of the time it was bought or sold through the year.
 
Equities-Based ETFs
Equity-based commodity ETFs hold mining companies or other commodity producers. For some commodities, equity-based commodity ETFs may be the only way to gain exposure these assets through an ETF.
 
While commodity producers may see profits rise if the commodity's price rises, it should be noted that the performance of commodity producers does not always follow the spot price of their underlying commodity since firms will have a range of factors that could affect their performances. For example, mismanagement, corruption, environmental phenomenon, labor strikes and lawsuits could negatively affect a company; whereas, producers may also make new discoveries or streamline efficiency to help boost profitability.
 
What Affects Commodity ETFs
Commodity ETFs are subject to the basic laws of supply and demand in the underlying commodities market. Any changes in normal supply or demand would immediately affect spot prices. For instance, weather conditions, bureaucratic regulation, maintenance problems, or other global or domestic events that could lead to rapid shifts in the normal supply chain.
 
Commodities may also experience pricing trends depending on the season of the year. Agricultural products, such as livestock or crops, will produce higher or lower yields for different months of the year. Energy commodities will see prices peak during months of high energy usage, depending on the severity of weather conditions.
 
Current inventories help buffer prices in the event of supply shocks. If a commodity market were to suddenly experience a supply drop, inventories would be able to satisfy demand over the short-term. If supply remains depressed, inventories would run low, which would raise prices, and demand see a drop. As inventories drop below that of demand, the commodity may experience a temporary front-month spike in prices.
 
Foreign exchange rates also affect commodities. Since most commodities are priced in the U.S. dollar, appreciations or depreciations in the U.S. would have a large impact on commodity demand in foreign markets. As the U.S. dollar weakens, overseas buyers see a buying opportunity and horde the commodity.
 
Additionally, if inflation is expected to increase, farmers will raise crop prices by the same percentage to keep up with living costs. By investing in commodities, an investor is able to hedge against such price increases due to inflation.
 
Overall, commodities tend to rise and fall along with the fortunes or misfortunes of the total economy. As an economy improves, people's lives get better, and more basic commodities are consumed. This is particularly evident in heavy industries that depend on base metals in building materials.
 
Commodity ETFs can be a good portfolio diversifier. Commodities tend to be negatively correlated with traditional bonds and equities - there is a low linear relationship between commodities and traditional assets. Allocating a portion of one's portfolio into futures-based or physically-backed commodities ETFs help reduce overall portfolio volatility.
 
Some commodities may potentially benefit from the world's growing population and emerging middle class, since population growth has to be maintained by basic food supply and the world's up-and-coming middle class will start demanding more protein-rich diets.