Many traders have been following the news headlines closely in the past few weeks. They have been feeling the heat of the raging inflation that has led them to take another look at their portfolios in the share market. When the costs increase and the user's buying power is decreased, it can lead to a negative impact on many firms and industries. One of the asset classes that has proved its constancy amidst the increasing prices of goods is the commodity ETF. It comes in various forms: energy sources, agricultural products, and metals. The instruments of various flavors have seen their values increase due to pressures caused by the high inflation. This has resulted in a very good time for most commodity ETFs and commodity shares.

The increasing geopolitical tensions between Ukraine and Russia have also added a lot of fuel to the fire for the increase in the prices of commodity ETFs. But taking exposure to the physical commodities is not so simple. There are futures brokers who are welcoming the smaller retail traders with some measures. But the overall learning curve can usually be very high. People who want to get a toehold in the sector may like to try out commodity ETFs. They help to get greater ease of usage, cost-effectiveness, and liquidity. CFRA Research analyst Arun Sundaram said, "Global commodity prices are surging on worries of supply of key inputs, ranging from crude oil to wheat and edible oils, heightening the risk that elevated inflation could persist longer than many anticipate."

Types of Commodity ETFs

There has been a lot of interest in the commodity ETF instrument by the investing public. The interest is also showing no signs of going away in the near future. In the sphere of commodities, there are some major methods to get some exposure. These include exchange-traded notes, futures-based funds, equity funds, and physically backed funds. All of these types have pros and cons. When an investor is trying to find out which commodity ETF is correct for their particular portfolio, they need to know about the aim of the fund and how it is going to get to that aim. Find out if the commodity ETF holds the physical commodity or utilizes futures contracts to get exposure. It is important to know if it has equities of firms involved in producing a certain commodity.

The decision to invest in the commodity ETF should be on the basis of more than just the name of the particular ETF. The name of the fund may have gold, natural gas, or oil included in it. But the investor cannot be sure how the fund gets exposure to that commodity. If you want to get the top selection for your own portfolio, you have to look at all the choices in commodity ETFs and find out which one will help you achieve your goals.

1. Physical commodity ETFs

The physical commodity ETFs have the ownership of the commodity. When you visit the official website of these funds, they give you all the details regarding the ETF. The investors get an ownership stake in the stockpile of bold bullion of the firm without having to receive the physical delivery or take care of the logistics such as insuring and storing the physical gold. Several commodity ETFs are on the market, such as ETFs Physical Swiss Gold Shares and iShares Comex Gold Trust. One of the issues for the people who want to hold such commodity ETFs is the implication of tax. Unlike the other ETF instruments on the financial markets, the funds backed by physical gold can be taxed up to one-fourth of the total amount as collectibles. So, the funds are better for long-term investors who want to diversify their portfolios.

2. Equity-Based Commodity ETFs

Investors can also use the firms that develop and store commodities to get access to them. A commodity ETF that is based on equities gives exposure to commodities by the shares of firms present in the particular sectors of commodities. The equity funds are great alternatives to ETFs that are backed by futures. This is because the latter may be subject to certain restrictions in trading and other regulatory rules. Also, the commodity ETFs backed by equities have better implications regarding taxations than the other funds with physical stockpiles of such precious metals. For instance, people wanting to get exposure to gold can get equity-based alternatives such as Market Vectors Junior Gold Miners and Market Vectors Gold Miners. The latter gives exposure to international firms involved in mining gold. This includes small, mid, and large-cap shares. The former tracks mid and small-cap firms involved in silver or gold mining.

Both the commodity ETFs are seen as shares for the purposes of taxation. This makes these funds better for short-term traders out in the gold market.

3. Futures-Backed Commodity ETFs

These commodity ETFs are created to give exposure to a specific commodity. This is done using swaps and futures. There is a great deal of uncertainty in investments that surround these kinds of ETFs. This is because their requirement to sell and purchase large amounts of futures contracts sometimes leads to influencing the futures' prices rather than only tracking the commodity prices. This can lead to the chance of commodity bubbles. So, the Commodities Futures Trading Commission has put forward a proposal of imposing limits on the positions taken in futures contracts. This has led to several funds to develop new mechanisms for tracking the underlying commodities.

4. Using ETNs Instead of Commodity ETFs

Another method to get the benefits of the commodities is by using ETNs. These are unsecured debts issued by a particular institution. These instruments are linked to many assets, such as currencies and commodities. It is created to have no tracking error between the underlying index and the product. The owners of any ETN will get the return of the underlying index. Only the management charges will be deducted. The commodity ETNs also give a very favorable treatment regarding tax when compared to commodity ETFs. Investors who keep a commodity ETN for a period of twelve months pay only a capital gains tax of less than twenty percent when they sell the product. The commodity ETFs backed by futures are taxed like future, and the profits are marked to the financial markets each year. There is a difference of eight percent in the taxation, which attracts a lot of investors to ETNs.

The category has a lot of advantages, and the tax benefits are huge. But still, the category is relatively unknown among commodity traders. This is because there is an inherent credit risk for the issuing bank. After the financial crisis which rocked the world more than a decade ago, it is not so tough to imagine that there can be failures in the banking system. But a long time ago, this would look like a rare occurrence that would happen maybe once in a century. Apart from the risk of credit, the ETNs that track the commodity futures also have some regulatory risks. As we have seen with ETFs backed by futures, the regulatory rules on the involvement of a fund in the futures market can also greatly impact an ETN.

Conclusion:

The commodity ETFs that are physically backed show the forces of demand and supply in the financial markets for the material. They also keep a close track of the prices in the financial markets. But such exposure is not possible with each commodity in the market. The commodity ETFs can be great tools for investors who would like access to the commodities but want to manage their risk and restrict their overall exposure to the financial markets. Most investors in the financial markets utilize commodity ETFs to hedge against the increasing prices of commodities or against high inflation. There is great ease of trading them that makes it very compelling for many investors. But there are a lot of drawbacks to all these funds. Each investor should ensure that they find out about all the drawbacks before making their purchase.