Investment Primer: The Commodity Composite

What, Why, and How of Commodity Funds

The Commodity asset class includes funds that provide exposure to raw materials, which are the building blocks of the global economy. The “why” for investing in commodities is primarily for diversification and inflation hedging. Commodity prices are driven by real-world supply and demand dynamics, which often causes their returns to be uncorrelated with traditional stocks and bonds. Furthermore, because inflation often means rising prices for raw materials, commodities can serve as a potential hedge against the eroding value of financial assets.

The “how” is critical, as commodity funds come in two fundamentally different structures:

Physically Held: These funds, typically only available for precious metals like gold and silver, purchase and store the physical commodity in secure vaults. Their value is directly tied to the spot price of the metal.
Futures-Based: The most common structure, these funds do not hold the physical commodity. Instead, they invest in futures contracts—agreements to buy or sell a commodity at a predetermined price on a future date. This is the only practical way to gain exposure to commodities like oil, natural gas, and agricultural products.

Deconstructing the Commodity Market

To effectively use commodity funds, it’s essential to understand the unique mechanics of futures-based funds and the three distinct composites within the asset class.

The Critical Role of Futures and “Roll Yield”

Futures contracts have expiration dates. To maintain exposure, a futures-based fund must sell its expiring front-month contract and buy a contract with a later expiration date. This process is called “rolling,” and its cost or benefit is a major driver of a fund’s return. This is determined by the shape of the futures curve:

Contango: This is when the price of a longer-dated futures contract is higher than the front-month contract. In this scenario, the fund is forced to “sell low and buy high” each time it rolls, creating a performance drag known as negative roll yield. Persistent contango can cause a fund’s return to significantly underperform the spot price of the commodity over time.
Backwardation: This is when the price of a longer-dated futures contract is lower than the front-month contract. In this scenario, the fund “sells high and buys low,” creating a performance tailwind known as positive roll yield.

To manage the impact of roll yield, futures-based funds employ different strategies, which can be identified in the Implementation field in the ETF Action database:

Expiry: Near: The fund holds the front-month contract to be most sensitive to the spot price. This strategy is most exposed to the effects of contango or backwardation.
Expiry: Laddered: The fund holds a portfolio of contracts with multiple expiration dates to smooth out the rolling process and reduce the impact of the front-month curve shape.
Expiry: Scored: The fund uses a rules-based or active strategy to select contracts along the futures curve that it believes will “optimize” the roll, aiming to minimize the cost of contango or maximize the benefit of backwardation.

The Three Commodity Composites

ETF Action organizes commodity funds into three distinct composites:

Comm: Multi-Sector: Groups funds that provide diversified exposure across multiple commodity sectors, such as energy, metals, and agriculture, within a single product.
Comm: Focused: Groups funds that concentrate their exposure on a single commodity sector (e.g., Energy) or a single commodity (e.g., Gold). This is the largest and most common type of commodity fund.
Comm: Specialty: Groups funds that provide exposure to unique, commodity-like assets that do not fit within the standard composites, such as carbon credits.

A Practical Guide to Locating Funds in the ETF Action Database

The commodity universe is segmented by both the type of commodity and the fund’s structure. ETF Action’s classification system allows users to precisely navigate this space.

Foundational Screening: Building the Initial Universe

Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
Step 2: Filter by Asset Class. Select Asset Class = Commodity.
Step 3: Filter by Composite. Select the desired composite (Comm: Multi-Sector, Comm: Focused, or Comm: Specialty).
Step 4: Filter by Category. This allows you to target a specific sector (e.g., Commodity: Focused – Energy, Commodity: Focused – Precious Metals).
Step 5: Filter by Segment & Group. Use these fields to drill down to a single commodity (e.g., Segment = Comm: Energy, Group = Crude Oil).

Advanced Filtering: Refining Your Peer Group

Sub-Asset Class: This is the most critical filter for structure. Use it to isolate Physically Held funds from Derivatives (futures-based) funds.
Implementation: For futures-based funds, use this filter to find a specific roll strategy (Expiry: Near, Expiry: Laddered, Expiry: Scored).
Brand (Issuer), AUM, Expense Ratio, Liquidity: Use these standard filters to narrow the list to viable candidates.

A Framework for Evaluating Commodity Funds

Evaluating a commodity fund requires a different approach than for stocks or bonds. The analysis must focus on the fund’s structure and its effectiveness at tracking the desired commodity’s price.

Risk/Return Analysis: The Importance of Benchmarks

The foundational step is to analyze a fund’s historical risk and return profile. ETF Action assigns a Beta Tracker to each category (e.g., DBC for broad commodities, GLD for gold) to provide a relevant peer for comparison.

Total Return: How has the fund performed over various time periods compared to its benchmark and, if possible, the spot price of the underlying commodity?
Standard Deviation (Volatility): Commodities are inherently volatile. It’s important to understand a fund’s volatility relative to its peers and the broader market.
Sharpe Ratio: Did the fund provide better risk-adjusted returns?

Quantitative Analysis: The Power of Look-Through Analytics

For commodity funds, “look-through” analysis is not about individual securities but about the structure of the commodity exposure.

For Physically Held Funds: The analysis is straightforward. The key is to measure the fund’s tracking error relative to the spot price of the commodity. A well-run fund should closely track the spot price, with the only deviation being its expense ratio.
For Futures-Based Funds: The analysis is more complex. The goal is to assess how effectively the fund’s roll strategy has managed the impact of contango and backwardation. Comparing the fund’s long-term return to the spot price of the commodity can reveal the extent of the performance drag (or lift) from roll yield.

Qualitative Analysis: Evaluating the Strategy

Structure & Tax Implications: This is a critical point. Many futures-based commodity funds are structured as Limited Partnerships (LPs) and issue a Schedule K-1 tax form, which can complicate tax filing. Other funds are structured as traditional ’40 Act funds (often using a subsidiary to hold the futures) and issue a standard 1099. Physically held gold and silver funds are typically structured as Grantor Trusts and are taxed as collectibles. Understanding these structural differences is essential.
Index Methodology: For passive funds, the key is to understand the index methodology, especially for funds with “scored” or “optimized” roll strategies. The prospectus will detail the rules-based process for selecting futures contracts.

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