Can Commodity ETFs Hedge Against Inflation?

With inflation surging on a year-over-year basis, it’s no surprise that investors are looking for ways to boost their returns in the hopes to stay ahead of inflation.

One way to add a little oomph to your portfolio could be with commodity exchange-traded funds. However, before you decide to add another asset class to your investment mix, it’s important to understand how commodity ETFs work.

Let’s take a look at what you need to know to decide whether commodity ETFs are right for you.

What is a commodity ETF?

A commodity is a physical asset, usually, one that comes from the earth in some way. A few examples are gold, crude oil, grain, palladium, industrial metals, cotton, and other physical assets that can be grown, mined, or drilled.

An exchange-traded fund (ETF) is a type of fund that uses pooled money as a way to invest in a basket of assets by tracking certain market benchmarks. Although similar to a mutual fund in that you get exposure to a variety of investments by purchasing a share, an ETF isn’t exactly a mutual fund. The main difference is that a mutual fund can’t be traded on an exchange like a stock, but an ETF can. A share of an ETF is traded just like a normal stock.

Commodity ETFs are ETFs specifically designed to provide exposure to specific commodities or a range of commodities. This provides investors with a method of adding exposure to these commodities to their portfolios by trading them on a stock exchange.

Additionally, commodity ETFs, just like ETFs in general, allow investors to be involved in a market without being experts in the field. When you buy a commodity ETF, you negate the need to research each stock individually. This makes it much simpler to invest in certain industries or commodities.

Can commodity ETFs hedge against inflation?

In general, commodity prices can potentially react quickly during periods of inflation because they often power the inflation rate. For example, changes in oil and gas prices not only closely mirror the inflation rate, but they contribute to it. A change in oil and gas often results in myriad price changes in other services and products.

That’s why some investors feel that exposure to commodity ETFs could act as a hedge against inflation. For example, a Vanguard report suggests that a 1% rise in inflation has the potential to result in a rise of 7-9% in commodities.

Over the 12-month period ending in February 2022, inflation hit 7.9%, according to the Bureau of Labor Statistics. On the other hand, according to the ETF Database, the average one-year return for a basket of 31 commodity ETFs was 45.20% as of April 1, 2022.

When looking at those numbers, it’s not hard to see that commodity ETFs have the potential to beat inflation. When you have concerns about inflation, adding some commodity exposure to your portfolio could help hedge against rapid and unexpected price changes. This is especially true for people looking for investing money in commodities without the complications that can come with accessing the commodities market.

Types of commodity ETFs

These ETFs could take several different forms. The most common types are:

1. Physical ETFs: These allow you to buy underlying physical commodities. As a result, you own the underlying asset, which isn’t usually the case with many commodity funds. Physical gold ETFs are common examples of this type of commodity ETF. You actually own a stake in the single commodity involved. However, it’s important to note that the tax category of these ETFs is the same as with gold bullion — as collectibles. Double-check the capital gains rate on a physical ETF like gold to ensure you understand how it works.
2. Futures-backed ETFs: Rather than getting access to the underlying physical asset, this type of ETF relies on commodity futures contracts. Investing in this type of ETF allows you to add exposure to your portfolios without needing to own the actual commodities. Futures are taxed differently in terms of capital gains, so it’s important to understand how adding these to your portfolio would impact your tax liability.
3. Equity-based ETFs: Another investment strategy is to buy ETFs that use the stocks of companies working with raw materials. For example, an ETF that covers oil companies or gold shares would be considered an equity-based commodity ETF.

Because ETFs trade like stocks do on the stock market, you are subject to the same trading fees as stocks. There are online brokers that don’t charge trading commissions on stocks, and you can usually trade ETFs without commissions as well.

However, you do need to be aware that an ETF will come with an expense ratio. Even though you may not pay trading fees, there are some expense fees involved. That said, many ETFs have relatively low expense ratios — though commodity ETFs can potentially have higher expense ratios than broader ETFs.

7 commodity ETFs to consider

Commodity ETFs may not be right for everyone, which is why it’s important to consult your own goals and portfolio strategy before purchasing shares in a commodity ETF. That said, here are seven commodity ETFs you might consider adding to your portfolio:

Invesco DB Commodity Tracking Fund (DBC)

This ETF is designed to track 14 of the most heavily traded physical commodities in the world. It does this by tracking futures contracts of these commodities, which are contracts that allow investors to buy or sell an asset at a predetermined price at a specific time in the future. However, DBC also includes some Treasury securities as a part of the fund. The idea is to gain some stable interest dividends while getting exposure to trading these commodities.

United States Commodity Index Fund (USCI)

The USCI commodity ETF also tracks 14 commodities futures contracts selected out of 27 potential contracts. These futures contracts change each month based on a variety of management factors.

Hartford Schroders Commodity Strategy ETF (HCOM)

This is an actively managed ETF that invests in commodity derivatives, which are financial contracts that get their value from the performance of their underlying assets. The goal of this ETF is to provide long-term total returns by choosing the assets under management that match the goals.

First Trust Tactical Commodity Strategy Fund (FTGC)

This is also an actively managed ETF. FTGC is designed to look for commodities and other assets that combine a relatively stable risk profile with total returns. Most of the commodities on this ETF are in the form of futures contracts.

KraneShares Global Carbon Strategy ETF (KRBN)

For those interested in climate change, this ETF’s goal is to support responsible ecological investing. It focuses on futures related to carbon cap-and-trade programs around the world, which provides a method for hedging risk by investing in carbon prices.

iShares S&P GSCI Commodity-Indexed Trust (GSG)

This is technically not an ETF, because it isn’t registered under the Investment Company Act of 1940. Instead, it’s a commodity trust you can invest in by buying shares of the trust. The S&P GSCI trust is highly speculative. It focuses on collateralized commodity futures, which are futures contracts that include Treasury bill purchases equaling the value of each contract.

Invesco Optimum Yield Diversified Commodity Strategy Strategy No K-1 ETF (PDBC)

As with DBC, this ETF focuses on specific commodity futures, but there are more assets included in it as well. There are Treasury bills, swaps, U.S. dollar liquidity portfolio, and other assets. The ETF’s goal is long-term capital gains.

How to get started with commodity ETFs

Getting started with commodity ETFs is fairly straightforward. As long as you have a brokerage account and know the ticker symbol of the ETF, you should be able to research it and buy its shares.

Because ETFs are traded on stock exchanges, you’ll need access to this market through a broker. A few of the brokers available to choose from are Robinhood, Fidelity, Stash, and E*TRADE from Morgan Stanley. Once you set up a brokerage account, you can fund it to begin investing money.

As you invest, make sure you carefully evaluate your choices based on risk and potential return. You can also compare expense ratios and other fees. For example, equity-based ETFs are most likely to have the lowest amount of risk and the most favorable tax situation. Additionally, an equity-based ETF often has low fees.

On the other hand, you might be able to make more money in a shorter period of time with a physical or futures-backed ETF. The downsides, however, are that there is a higher risk and the tax situation can be more complicated. Additionally, you might pay higher expense ratios with these types of ETFs.

Alternatives to commodity ETFs

If you’re not interested in commodity ETFs, there are other options to consider to hedge against inflation. Here are a few ideas that may appeal to people who like the idea of alternative investments that could potentially beat inflation:

Exchange-traded notes (ETNs)

This type of investment represents unsecured debt in the form of a security issued by an underwriting bank. This security can be attached to commodities (as well as currencies) and presents another way to add commodity exposure to your portfolio. The tax treatment with ETNs can be more favorable than with physical and futures-based commodity ETFs, but there are other risks, such as credit risk, because these are related to debt.

Futures contracts

If you’re more interested in directly trading futures contracts, you have the opportunity to define your own exposure for each commodity. However, futures contracts may have a steeper learning curve than ETFs. Although you can execute simple market orders to trade ETFs like stocks on the market, futures trading can be more complicated. Additionally, futures are taxed differently than stocks, so you have to pay attention to your tax liability.

Commodity-backed crypto tokens

Another potential route to gain exposure to commodities is investing in commodity-backed crypto tokens. If you’re interested in cryptocurrency, this can be a way to access blockchain assets that are connected to commodities. For example, Paxos is the issuer of PAX Gold (PAXG), a token that represents ownership of physical gold. You can buy and sell the token with relative ease on a crypto exchange without having to worry about storing the gold.

FAQs

Bottom line

Understanding your own portfolio goals is an important part of deciding what assets to include. In many cases, ETFs can help you quickly and easily build a diverse portfolio that helps you meet your financial goals — including promoting long-term growth and hedging against inflation. However, commodity ETFs can provide some unique risks that are essential to take into account. They can also come with higher expense fees than broader ETFs.

Because some commodity ETFs, especially those connected to futures contracts, can have high volatility, it’s important to carefully consider your risk profile before investing in them.