What is a Commodity ETF and How Does it Work?

Building a diverse portfolio can help investors benefit from multiple asset classes while also protecting them from the uncertain financial and economic environment. Among the various asset classes, investors often consider investing in commodities; however, many are unsure about how to enter the commodities market.

Here’s where a commodity ETF comes into play, allowing investors to begin investing in commodities easily. Read on to learn more about what they are and how they can help you.

What is a Commodity ETF?

Before we look at what a commodity ETF is, let’s understand what an exchange-traded fund (ETF) is. An ETF is a financial instrument that is traded on the stock exchange, similar to shares of a company. ETFs pool money from investors and invest it in a wide range of securities, including stocks, bonds, indices, and commodities.

An ETF tracks a particular asset, such as an index or commodity, and aims to replicate the returns of the underlying asset.

A commodity ETF is an ETF that provides investors with exposure to commodities such as gold, silver, or oil, without requiring them to take physical delivery or store the commodities. Commodity ETFs track the price of a particular commodity or an underlying commodity index.

How Does a Commodity ETF Work?

Commodity ETFs aim to replicate the returns of the underlying commodity or index closely. To achieve this, an ETF will invest in bullion or derivatives like futures contracts, which can help it generate returns that are identical to the underlying commodity.

However, ETFs may not always be able to accurately replicate the returns due to tracking errors and, in the case of future-based ETFs, roll costs or contango/backwardation effect.

For example, a gold ETF allows investors to invest in gold without having to physically hold the metal. A gold ETF will track the price of gold by investing in the physical metal. In India, gold ETFs are required to have physical gold of 99.5% purity rather than using futures. A rise in the price of gold will lead to an increase in the value of the ETF, and if the price of gold decreases, the value of the ETF will also decline.

Types of Commodity ETFs

Here are the common types of commodity ETFs

Benefits of Investing in Commodity ETFs

Enhanced Diversification

One of the key benefits of commodity ETFs is that they offer diversification to investors. Investors can gain exposure to various commodities, allowing them to build a well-rounded portfolio.

Inflation Hedge

Commodities such as gold are considered to be a hedge against inflation. By investing in commodity ETFs, investors can protect themselves from risks arising in an inflationary environment.

Convenience

Investing in commodities can often be challenging; however, commodity ETFs make it easy to invest in commodities. Investors can buy and sell a commodity ETF as they please. There is also no need to store the commodities physically.

Liquidity

Commodity ETFs are traded on stock exchanges and have higher liquidity, allowing investors to enter and exit their positions at fair prices.

Unlike equities, commodity ETFs generally do not generate dividends or interest income. Returns are purely from price movements.

Risks Associated with Commodity ETFs

• Commodity prices are highly volatile. The demand & supply, geopolitical events, supply chains, and weather events impact the price of a commodity. The volatile nature of commodity prices also affects the value of commodity ETFs.
• Although commodity ETFs can be a great way to invest in commodities, it is essential to research the ETF. Investing in an ETF with a high tracking error can result in deviations from the expected returns. Additionally, costs such as management fees and the expense ratio can also drive up the costs of investing.
• Commodity ETFs also don't generate any income in the form of interest or dividends. Futures-based ETFs may also face losses due to negative roll yield in contango markets.

Commodity ETFs vs Equity ETFs

How to Invest in a Commodity ETF

• To invest in a commodity ETF, you first need to create a demat and trading account with a SEBI-registered broker or depository participant.
• Investors should know their investment goals, investment horizon, and risk appetite before investing.
• Pick a commodity that aligns with your investment goals. For example, gold for an inflation hedge or natural gas for exposure to energy commodities.
• Search for an ETF and research its past performance, tracking error, management fees, and other associated costs. Compare it with similar ETFs to pick the most suitable option.
• Place an order for the ETF through your trading platform.
• Once the ETF is credited to your demat account, monitor it regularly and make any necessary adjustments.

Taxation of Commodity ETFs

Commodity ETFs are taxed differently from equity ETFs — taxation depends on whether the ETF is classified as equity or non-equity.

Gold ETFs are treated as non-equity ETFs. If sold within 12 months, gains are taxed as per the investor’s income tax slab rate. If held for more than 12 months, gains are taxed at 12.5% without indexation, applicable from April 1, 2025.

Debt ETFs and Other Non-Equity ETFs, if sold within 24 months, gains are taxed as per the income tax slab rate. If held longer than 24 months, gains are taxed at 12.5% without indexation.

In the case of equity ETFs, if they are sold within 12 months, they attract 20% short-term capital gains tax (STCG) under Section 111A. If held for more than 12 months, long-term capital gains (LTCG) above ₹1.25 lakh are taxed at 12.5% without indexation under Section 112A (effective July 23, 2024).

Who Should Invest in Commodity ETFs?

Commodity ETFs are an ideal investment option for any investor who wants to gain exposure to the commodity market without having to directly invest in commodities. It is also suitable for investors looking to build a diverse portfolio and hedge against inflation risks.

Conclusion

Investing in commodity ETFs is a simple and quick process. Through commodity ETFs, investors can not only benefit from the price movements in commodities but also spread risk across asset classes and create inflation hedges. Investors should carefully study a commodity and ETF before investing to ensure that it aligns with their investment goals and risk profile.