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Since the dawn of modern investing, stocks and bonds have been the cornerstones of a diversified investment portfolio. But in recent decades, more and more investors have started participating in the commodities markets. There are many different ways to invest in commodities. You can buy them outright, or through futures contracts. Or you can own them indirectly by investing in commodity stocks (such as oil & gas exploration companies). Another increasingly popular option is to buy a commodity ETF or mutual fund. Many investors are familiar with mutual funds, and they have a lot of things in common with ETFs. An ETF is simply an Exchange Traded Fund. That means you can buy and sell its shares intraday, like a stock, on a stock exchange.

Five years ago, there were only a handful of commodity ETFs, but now there are over 100 listed funds. There are many different kinds of funds. and each invests in a specific type of commodity or basket of commodities. Here’s an overview of the different commodity ETF categories:

• Commodity index funds. which invest in a broad basket of commodities. Popular examples include the iShares S&P GSCI Commodity-Indexed Trust ETF (ticker: GSG) and the PowerShares DB Commodity Index Tracking Fund (ticker: DBC).
• Agricultural commodity ETFs (some investors refer to these as an agriculture ETF). These invest in a specific agricultural commodity (such as a wheat ETF or a corn ETF), or a basket of agricultural commodities.
• Energy ETFs, including for example the United States Natural Gas ETF (ticker: UNG) and United States Oil ETF (ticker: USO).
• Precious Metals ETFs, such as the popular gold ETF. the SPDR Gold Shares (ticker: GLD), or silver ETF: the iShares Silver Trust (ticker: SLV).
• Industrial Metals ETFs track individual commodities such as copper, uranium, or broader baskets of industrial metals.

What’s In a Commodity ETF?

Many commodity ETFs hold futures or asset-backed contracts: they don’t buy the actual commodities but hold a contract to purchase them at some time in the future at a set price. But some commodity ETFs do actually buy hard assets. One example is the SPDR Gold Shares ETF (GLD). When investors purchase its shares, the fund invests in actual gold bars, stored in bank vaults in London and elsewhere. Some investors prefer these hard assets over a “piece of paper” (futures contract).

Some commodity securities are structured as an Exchange Traded Note (ETN). While these are similar to an ETF, there are some important distinctions. In particular, ETFs and ETNs are treated differently for taxation purposes. Gains on ETNs held for over one year are generally treated as long-term capital gains, whereas futures-based ETF gains are taxed annually and reported on IRS Schedule K-1. Also, because ETNs are a type of debt security (bond), their value may change based on the credit rating of the issuer. For example, if an issuer’s credit rating is downgraded, the ETN price may drop even though there’s no change in its underlying commodity index or futures contract. On the plus side, ETNs typically do a better job of tracking the underlying commodity prices.

Since commodity futures are leveraged investments and the goal of most commodity funds is to track the unleveraged (1x) return of their underlying commodity or index, the funds only invest a part of investor purchases in futures contracts, and use the remaining funds to purchase safe government bonds (such as U.S. Treasury Bills). The interest from these bonds helps to boost returns and offset the fund expenses.

Why Invest in Commodities?

There are many different reasons and strategies to participate in the commodities markets, including:

• Strategic buy/hold allocation for hedging or diversification purposes. Commodities can diversify an investment portfolio, because they’re often not correlated to other asset classes like stocks and bonds. For example, you could allocate a small percentage of your portfolio to a gold, silver, or other commodity ETF.
• Tactical asset allocation: commodities don’t always rise in value, so some investors prefer a tactical allocation that aims to only invest in them when they are trending up.
• Managed Futures: professionally managed funds that often employ a trend-following strategy to buy and sell (or short) commodity futures. Many of these funds focus on diversification, risk-management, and remaining uncorrelated to other asset classes like stocks.

As with any other investment, conduct lots of research before you decide whether or not to include a commodity ETF in your investment portfolio.

In Summary

A commodity ETF means different things to different investors:

• It can refer to a commodity index fund that tracks a broad basket of commodities
• Or it can focus on a specific category such as Energy, Precious Metals, Industrial Metals, Livestock or Agricultural commodities
• Or it can track a single commodity, such as a gold ETF .

Whatever your definition, theres probably a fund among the 100+ exchange listed securities to fit your needs.