Commodity ETFs

Two structures, one label 

Commodity funds are grouped together by what they reference and separated by what they hold, and the second distinction is the one that governs their behaviour. A physically backed fund holds the raw material itself. SPDR Gold Shares and the iShares Silver Trust are of this type: bullion sits in a vault with a custodian, an allocated bar list is published, and each fund share represents a fixed and slowly shrinking quantity of metal. A futures based fund holds no commodity at all. The United States Oil Fund is of this type: it holds exchange traded futures contracts on crude oil, together with the cash collateral posted against them.

The reason for the split is physical rather than financial. Metal can be stored indefinitely at a modest cost, so a fund can simply buy it and keep it. Crude oil, natural gas and agricultural products cannot be warehoused by a fund in any practical quantity, so exposure to them has to be obtained through contracts that expire and are replaced. Every distinctive feature of a futures based fund follows from that replacement.

The metal trusts 

A physically backed metal trust is the simpler instrument. Its share price tracks the spot price of the metal closely, because the fund holds the metal and creation and redemption is settled in metal. There is no income: bullion pays no interest and no dividend, so the fund's expenses cannot be met from a cash stream. They are met by selling a very small quantity of metal at intervals, which is why the amount of metal represented by one share declines slowly and predictably over the life of the fund.

That arithmetic is the whole of a metal trust's structural divergence from its metal. Over a short period it is invisible. Over years it accumulates, and it is the reason a chart of a metal trust and a chart of the metal do not perfectly overlay even when nothing unusual has happened.

The roll, and why it separates a futures fund from spot 

A futures contract has an expiry date and a delivery obligation attached to it. A fund that intends to keep its exposure indefinitely must therefore sell the contract it holds before that date arrives and buy a later dated one, an operation called the roll, repeated on a published schedule for as long as the fund exists. The roll is not a cost in the sense of a fee. It is an exchange of one contract for another at their respective market prices, and whether it helps or hurts depends entirely on the relationship between those two prices.

When contracts further out are more expensive than the near contract, a market state called contango, the roll sells the cheaper contract and buys the dearer one, so fewer contracts are held afterwards for the same money. Repeated month after month, that produces a return below the change in the spot price, and the shortfall is often described as roll drag. When contracts further out are cheaper, a state called backwardation, the roll works in the opposite direction and adds to the return. Neither state is permanent and many commodities alternate between them.

What moves commodity funds 

The first driver is the commodity itself, and its drivers differ by material. Gold and silver respond to real interest rates, to the dollar, to central bank buying and to demand for a store of value in periods of stress, with silver carrying an industrial demand component gold does not. Crude oil responds to production decisions by the largest exporters, to inventories, to refinery activity and to the pace of global demand. Industrial and agricultural materials respond to production, weather, freight and inventory cycles.

The second driver is the currency the commodity is quoted in. The major raw materials are priced in dollars, so a change in the dollar alters the price of the same physical quantity to buyers using other currencies, and dollar strength and commodity prices are conventionally described as inversely related for that reason. The third driver is the fund's own structure, which is the roll for a futures based fund and the expense accrual for a metal trust.

Trading hours introduce a fourth effect. Commodity funds are listed on a stock exchange and trade in its session, while the futures markets underneath them trade for far longer. A fund's opening price therefore reflects everything that happened in the commodity overnight, which is why commodity funds gap at the open more often than funds holding shares that trade in the same session.

A fund on a commodity and a contract on the commodity 

The same underlying material can be reached through a fund's listed shares or through a contract written on the commodity directly, and the two are not equivalent. A contract on spot gold references the metal's own quotation and carries no fund expense and no roll. A contract on a metal trust references a listed security whose price includes the fund's accrued expenses and can sit at a premium or discount to its metal. A contract on a futures based fund carries the roll as well, so its result over a long holding period reflects the shape of the futures curve in addition to the commodity's price.