Bringing commodity markets to all investors

Exchange Traded Funds (ETFs) commenced trading in 1989 on the American and Philadelphia Stock Exchanges. They can hold any asset, including commodities. The first ETF products were a proxy for the S&P500 index. An ETF is an investment fund that trades on stock or equity market exchanges.

Exchange Traded Notes (ETNs) differ from ETFs in that they are a debt-linked security issued by only one creditor, usually a banking institution. Therefore, there is a higher degree of credit risk inherent in ETN products when compared with ETF products.

ETF and ETN products representing commodities grew in popularity during the secular bull market for commodities that began in earnest in 2004. Since then ETF’s and ETN’s that seek to replicate results in precious metals, base metals, grains, soft commodities, energy and even animal proteins have appeared on the scene. The liquidity of these products varies and often mirrors the liquidity in the underlying commodities they seek to replicate. Some of these products take advantage of rising prices and others falling prices.

What to look for with ETF and ETN Products

When considering adding ETF or ETN products based on commodities to your portfolio, there are a number of issues to look for. The most important is liquidity. For all investors and traders it is important to have the ability to buy and sell these products on narrow bid/offer spreads- or the differential between buying and selling offered by market makers in these products. You can monitor liquidity in two ways. First, you should look at the net asset value (NAV) of the product. An ETF or ETN with a NAV of $1 billion will have greater liquidity than one with $10 million. Secondly, investigate how many shares of the product trade on an average day. This will alert you to those products that trade actively traded versus those that are less active. Activity equals liquidity.

Next, check out the cost of trading. Aside from brokerage commissions, ETF and ETN products have embedded costs called expense ratios. These expense ratios are annual fees charged to the fund shareholders to cover expenses and they vary from product to product. For example, the GLD, the most popular and actively traded gold ETF with a huge NAV has an expense ratio of around 0.40%. CORN, a smaller ETF that seeks to replicate the performance and price of corn has an expense ratio of 7%. Each ETF and ETN usually states expense ratios in their disclosure documentation. Leveraged ETF and ETN products tend to have higher expense ratios than non-leveraged ones.

Finally, some of these products track the underlying assets they purport to represent well and others not so well. Take a good look at how the ETF or ETN product you are considering correlated with the asset it represents over short, medium and long periods of time in order to insure you are getting what you pay for. Make sure you do some analysis and your homework before you trade or invest in these products.

To leverage or not to leverage

ETF and ETN products brought new investors and traders to the commodity markets since their introduction. Before these products became available, those who wished to invest in or speculate on the direction of commodity prices could only go to the futures or physical commodity markets. ETFs and ETNs, which trade on the stock exchanges, have brought broader participation to the commodities arena. Futures markets offer participants the opportunity of tremendous leverage. The ETF and ETN designers have developed products that will perform two or three times the move in the underlying asset. For example, if you think the price of natural gas is going to go higher quickly UGAZ is a bullish ETN that purports to perform three times the performance of natural gas prices on the upside. On the other hand, DGAZ is a bearish ETN that seeks to perform three times the performance of natural gas prices to the downside. Both of these ETN products are fairly liquid- they have net assets in the hundreds of millions and trade millions of shares each day. Both UGAZ and DGAZ have expense ratios that are on the high side at 1.65% because they are leveraged instruments. Leveraged ETF and ETN products are generally more appropriate for short-term forays into markets.

There are literally hundreds of commodity ETF and ETN products offered in the equity markets today. There are new products coming out each week. These instruments are a great way for investors and traders to participate in commodity markets. Make sure to do your homework, each product is different in terms of cost, ease of trading and effectiveness.