Commodities, everyone knows what they are. Commodities markets are the oldest markets in the world. They range from the foods that feed us - like wheat and potatoes, fish and pigs - to the industrials that power our houses and cars - like copper and oil.

Bonds might be nice but if you're hungry you can't eat debt. Buying equities in tech companies may be well and good, but if there's no copper there can be no electrical devices. While less glamorous than other capital markets, commodities markets are arguably more important.

But how do commodities get rolled into ETFs? Why should investors care? And what should anyone considering buying commodities know? Below is a guide to commodity ETFs.

Introducing ETCs

In the land of ETFs, acronyms abound. ETFs - emphasis on the F - are meant to be funds, where bonds and equities are piled in one place. ETNs are meant to be notes of unsecured debt that track the price of anything, from ethereum to cocoa. And ETCs are exchange traded commodities, providing a vehicle through which commodities can be bought and sold on exchange.

Commodity ETFs (ETCs, from here on in) provide investors with exposure to all sorts of commodities from aluminium to zinc. They allow investors with a strong view on any commodity to simply buy direct exposure to a commodity.

Historically this has not been possible. Investors wishing to buy commodities had to buy companies in the industry - i.e. buy shares in a gold miner. Or buy and horde the commodity - i.e. buy gold bars and stick them in a safe. And while commodity indexes have existed since the 1950s only since ETCs, have investors been able to invest in these indexes directly.

Physical ETCs: tracking the spot price

The majority of money that sits in ETCs, sits in ETCs that physically hold the commodity and tracks the spot price. This is for one reason: precious metals, especially gold.

Physically backed ETCs are almost unique among all ETFs because they do not track an index per se. What they track is the spot price, which can be represented in an index very simply but is not the same as tracking an index itself.

Physical ETCs are usually structured as debt certificates, where the debt they owe is bars of precious metal, like gold or silver. This means investors who own ETCs are guaranteed to track the spot price because their ETC is directly plugged in to physical metal.

Physical ETCs are very popular. In the US alone, there is more than $45bn sitting in physically-backed gold ETCs. For investors the appeal is obvious: both the chance to buy gold, a safe haven asset, with the security of having the gold bars in a vault and the additional security of having them delivered on request. All this for a very small ETF fee, between 0.20 and 0.40%, depending on the issuer.

Why do only precious metals do this? Partly because agriculture and livestock commodities perish. And many industrials and energy commodities have regulations preventing them from being hoarded.

Commodity futures indexes

When commodities cannot be held physically they track futures indexes. The vast majority of world trade in commodities is in futures, which means that when ETCs want exposure, futures are where they must go.

But tracking futures indexes is a bit trickier than it sounds. When investors get into commodity futures there are four different types of index they should know.

Type 1. Excess Return

Excess return = Spot Price + Roll Yield

Excess return indexes are the simplest commodity indexes as their only component is commodity futures contracts. If there were such a thing as "plain vanilla" commodity indexes - which there isn't, commodities are among the trickiest types of index - then it would be excess return indexes.

Excess return indexes build in two types of return that investors should know. The first is the spot price. The spot price is the price of a futures contract at a point in time - 'on the spot'. If the spot price goes up, investors make money - as with any kind of investment.

The second type of return is roll yield. Roll yield is a type of return unique to futures-backed ETFs and ETCs. Futures contracts cannot be held forever. They have delivery dates. To prevent delivery, old futures nearing expiry must be sold and new ones with later expiry must be bought.

The old contract being sold and the new one being bought are usually very differently priced. This can mean that investors make money if the new futures contract costs less than the old one. And that investors lose money if the new futures cost more than the old ones they sold. When investors make money on the roll, it's called backwardation. When they lose money, it's called contango. (For a more detailed treatment of this subject, please read the chapter on contango or backwardation).

Roll yield offer a second source of return (positive or negative), which is built into commodity indexes. And for excess return commodity indexes these are the two sources of return: spot price and roll yield.

Type 2. Total Return

Total return = Spot Price + Roll Yield + Collateral Yield

The second type of commodity indexes are called total return. Total return indexes are similar to excess return indexes, but add a third source of return: collateral yield.

What's collateral yield?

When commodity investors buy futures they often do not invest exclusively in futures contracts; they also invest in collateral (usually T-bills). Why? Because exchanges often require it.

Under most exchanges' rules, investors only have to pay a margin on any commodities futures, while the remaining price of the futures contract can be put in safe collateral to earn risk-free interest (usually T-Bills). This way the seller of the futures contract knows that the investor can pay, and the investor knows the money they've set aside is in a safe liquid asset. (If investors hold the futures contract on the delivery date, the collateral will be taken to pay for the futures contract in full - but that rarely happens).

Only total return indexes include this source of return. At the time of writing, most futures indexes in Europe, Australia and North America use total return indexes. The two major global ETC providers, US Commodity Funds and ETF Securities both use total return indexes.

Type 3. Currency hedged

Currency hedged = Spot Price + Roll Yield + Hedge Impact/Currency Basket Yield

Some commodity indexes also provide currency hedging, which can be very helpful for investors outside the US.

For example, if I invest in an oil ETC listed in US dollars, I am also vulnerable to any movements in the US-AUD exchange rate as well as the price of my ETC. So if my dollar-listed oil ETC rises 10%, I should be very happy. But if the US dollar then falls 5% against my home currency (AUD), I lose half my gains. By hedging currency, I may not get the full gains of a rising dollar, but I'm also spared the worse losses if the dollar falls.

Currency hedging in commodities is almost exclusively of interest to investors outside the US. This is because commodity futures are priced in US dollars. And the US has the largest commodity futures markets in the world. This means there is usually a negative correlation between commodities and the US dollar (particularly oil and gold, which are often bought as hedges against the dollar), while there is a positive correlation between major commodity exporter currencies - like Australia and Canada.

How do commodity indexes add currency hedging? Usually by building in a sub-index (like a basket of currencies with Bloomberg, or currency forward contracts with MSCI). The currency hedged index is then calculated as the product of the unhedged commodity index and the hedging index, whatever it is.

Type 4. Leveraged, inverse and leveraged inverse commodity

The final type of commodity index are also the most fun (to write about, at least) and risky. Leveraged ETCs try to give multiples of the performance of an index. Inverse ETFs by contrast, try to give the opposite performance of an index and offer ways to profit from downward moving markets. Leveraged inverse ETCs (sometimes called "ultra-short") put both dynamics together, and give a multiple of the inverse performance of an index.

Leveraged ETCs come with levels of leverage. The lowest level is 2x - which doubles the movements of an index. The next is 3x - which gives triple. And the highest, at least in the US, is 4x leverage which gives quadruple the performance of an index. (The SEC originally barred this type of product but recently gave 4x leveraged products the greenlight).

A word of caution: daily resets

Leveraged ETCs might sound great and like an easy way to make money, after all, if the gold price has gone up on aggregate over the past 50 years, why not just invest in a fund that gives triple the performance of gold? But this is where rebalancing comes in. Leveraged ETCs are rebalanced every day at the end of trading, meaning they give double the daily percentage movement of a commodity. This means that their long-term performance is vastly different from the performance of their underlying index. The SEC gives the following warning on its website:


"Let's say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do - it produced daily returns that were two times the daily index returns. But let's look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return."

This effect can be particularly acute in volatile markets. It is for this reason that most experts will warn that leveraged and short ETCs should not be held for much longer than a few weeks.