Inflation, defined as a persistent increase in the price of a general basket of goods and services over time, can greatly erode the purchasing power of your investments. Generally, as inflation trends higher, the overall returns expected from your investments decrease.
This is due to the relationship between nominal versus real returns. Nominal returns represent the absolute increase in the value of an investment, whereas real returns account for the effects of inflation. To calculate real returns, investors must adjust nominal returns for inflation.
For example, if an investment has a nominal return of 7% and inflation is 3%, the real return is approximately 4%. Therefore, inflation reduces the real return on investments, which makes it essential for investors to consider its effects when investing.
To hedge against inflation, some investors look to commodities, like energy resources, precious metals, and agricultural products. Commodities tend to have a positive correlation with inflation given their role as major inputs for calculating Canada’s Consumer Price Index (CPI), a key gauge of overall inflation in the economy.
As a Canadian investor, understanding your options for dealing with inflation is essential for preserving and growing your wealth. However, gaining direct commodities exposure can be cost-prohibitive and inaccessible for the layperson. The alternative is a commodity exchange-traded fund, or ETF, that can provide exposure via any brokerage account.
Here's all you need to know about investing in commodity ETFs for inflation protection.
Introduction to Commodity ETFs
Commodity ETFs are open-ended investment funds that hold a basket of commodity assets, allowing them to provide exposure to commodity price movements.
As their name suggests, shares of ETFs trade on an exchange like any other stock. When investors purchase a share of a commodity ETF, they receive exposure to the risks and returns of the underlying commodity basket.
It's important to understand that commodity ETFs can be constructed in different ways. That is, the basket of commodity assets they hold can be quite varied. In general, there are three types of commodity ETFs, with each possessing unique benefits and risks:
- Physically-backed ETFs: These ETFs hold physical commodities that can be stored long-term, such as gold or silver bars, in secure audited vaults. They provide direct exposure to the price movements of the underlying commodity.
- Futures-based ETFs: Some commodities like oil, natural gas, soybeans, wheat, and corn are difficult to store long-term. To gain exposure to them, some commodity ETFs invest in futures contracts, which are agreements to buy or sell the commodity at a predetermined price on a future date. These ETFs do not hold the physical commodity but track its price through the futures market.
- Commodity producer-based ETFs: Finally, some commodity ETFs invest in the stocks of companies involved in the production, exploration, or processing of commodities. An example would be an energy sector ETF or an oil & gas industry ETF. Commodity producers provide indirect exposure to commodity prices through the performance of these companies.
It's important to note that these three categories are not mutually exclusive. Some ETFs may provide exposure to two or more of the above depending on their strategy.
Benefits & Risks of Commodity ETFs
Historically, commodity ETFs have possessed a lower correlation with stock and bond markets, potentially allowing them to act as useful diversifiers in a portfolio. They have also historically performed well during periods of elevated inflation compared to stocks and bonds.
However, commodity ETFs also pose some unique risks, such as high volatility and contango, a market condition in which the futures price of a commodity is higher than its current, or spot price. The latter is a key risk that affects some futures-based commodity ETFs.
Futures-based ETFs must periodically "roll" their futures contracts, which means selling near-term contracts and buying longer-dated ones to maintain exposure to the commodity. When the market is in contango, the longer-dated contracts are more expensive than the near-term ones.
This price difference leads to what is called a "negative roll yield", as the ETF must sell the cheaper contracts and buy the more expensive ones. Over time, continued negative roll yield can erode the ETF's returns and cause significant underperformance.
How to Invest in Commodity ETFs in Canada
The versatility of all ETFs, not just commodity ETFs, enables Canadian investors to invest with ease. Buying shares of a commodity ETF can be as simple as searching its ticker symbol on your brokerage platform, specifying the number of shares and desired price, and submitting an order.
However, there are several considerations Canadian investors may wish to give careful thought to before deciding whether or not to invest in a commodity ETF.
A great place to start is the ETF Facts document, which summarizes key fund information in a transparent, simple, and comparable manner. Important things to note include:
- The ETF's management expense ratio, or MER. This is the overall fee an investor can expect to pay on an annual basis as a percentage of their total investment.
- The ETF's inception date and current size in terms of assets under management.
- The ETF's exchange, ticker symbol, and currency denomination.
- A snapshot of the ETF's current portfolio in terms of top 10 holdings and investment mix by asset class, sector, or geography.
- A measure of the ETF's distributions, which are periodic payments made to investors.
- A gauge of the ETF's risk rating, which is based on the historical volatility of the fund. Keep in mind that this does not predict the future and can change over time.
- The ETF's historical performance on both a trailing and annual basis. Again, it’s important to remember that past performance is no guarantee of future performance.
Given the relative complexity of commodity ETFs, it is all the more important to critically review an ETF's holdings and strategy. This means getting a sense of what commodities the ETF is invested in and what strategy it uses to manage the portfolio.
Conclusion
In summary, inflation can have a significant impact on investment returns by eroding the purchasing power of returns and negatively affecting the performance of equities and fixed-income assets. However, investors have options at their disposal for protecting against it.
To shield portfolios from the effects of inflation, investors can consider diversifying their investments across various asset classes that may provide a hedge against inflation. A popular choice are commodities, which are readily accessible via the ETF structure.
Commodity ETFs can offer inflation protection, diversification, and liquidity benefits to Canadian investors. However, before purchasing a commodity ETF, investors need to understand the unique risks and attributes of this ETF type such as high volatility and possible contango.
As with investing in any ETF, undertaking careful due diligence is essential for success. For commodity ETFs, this involves understanding the ETF Facts document and assessing the fund’s strategy, holdings, fees, and risk against your personal risk tolerance, investment objectives, and time horizon.
This content was originally published by our partners at the Canadian ETF Marketplace.