What is a Commodity ETF and Why Do They Stink?

What is a commodity ETF? They are ETF investments that buy …you guessed it….commodities. So…what is a commodity?

That’s simply a tangible good that is the same (within it’s grade) no matter where you buy it. Gold is gold. Corn is corn. Wheat is wheat. Lumber is lumber. It’s all the same and there are no “branding” issues.

Why would anyone want to buy a commodity? If you are a manufacturer and need the commodity to produce your goods, you have to buy it. If you aren’t interested in consuming the commodity, you still might be interested in investing in it. That’s because you think the price of that commodity is going to rise.

One commodity that has sparked a lot of interest over the last several years is gold. Because people have a (justified) fear about inflation, they have been interested in gold. What’s happened is that as the value of the dollar decreased, the value of gold has gone up. So gold is said to store it’s value and that’s a good thing when the dollar is losing it’s value. But should you buy gold now?

Well, gold isn’t the only hedge against inflation. Other commodities have also risen as a result of the general fear of inflation. Oil, cotton, sugar, and wheat (to name a few) have all seen dramatic rises in prices over the last several years. But they’ve also seen steep decreases in price lately.

As folks noticed these price fluctuations, they became interested in investing in the commodity ETFs. There are hundreds of them on the market and more coming daily. The fees are relatively low and the offer investors a chance to get a piece of the commodity action even though they may not know a lot about those commodities. They also have very low minimum account sizes so it’s easy for just about everyone to get involved who wants to.

But according to Bloomberg Business Week, commodity ETF’s are the “worst investment in America”. They are bad deals for you for a few reasons.

First, commodities is a hard game to win at. You shouldn’t get involved if you don’t know what you are doing. You have to be a sophisticated investor and have lots of time to watch your investments. Commodities are extremely volatile so you have to be willing to take a great deal of risk. In order to have any chance at making money with commodities over the long run, you have to have a great deal of money, time and expertise.

To make matters worse, when you buy commodities within a fund or ETF, you take on even greater risks. According to Investment News, the commodity ETF often fails to perform like the underlying security. In other words, lets say you love cotton and want to buy cotton. You are convinced that the price is going to the moon. Because you love cotton but don’t have the money to buy futures contracts, you buy a cotton ETF. You would expect to see the price of the ETF move more or less like the cotton contracts but they often don’t.

My experience tells me that people often buy commodity ETF’s because they are speculating on the price — not because they have any understanding of the investment. I’m not a huge fan of speculating so that’s why I suggest you stay away from these kinds of investments.

Have you had a different experience with commodity ETFs?