Why Should I be Extremely Careful with Commodities ETFs?

There are some things to keep in mind when investing in commodities and their ETFs. Most commodities trading revolves around who owns a hard asset and when.

ETFs occupy a space in the commodities world that is somewhat unique. An ETF such as the Crude Oil Index does not physically buy millions of barrels of oil and store them. It buys financial instruments which theoretically should reflect the price of oil.

The problem with such a strategy is that since ETFs do not take physical delivery of the underlying commodity, the instrument they use might significantly diverge from the price of the commodity.

There is a phenomenon is known as “contango,” which can significantly alter the price of the ETF and cause a divergence between the price of the ETF and the underlying commodity. The second area of concern with commodities ETFs is when they claim to be in possession of physical quantities of the underlying commodities, such as gold.

While we aren’t accusing the companies who run such ETFs of misleading their investors, there are abundant rumors that they don’t have enough of the physical commodity to cover the amount of outstanding shares. Technically speaking, you can exchange the shares of a gold ETF for physical gold, but it is not clear what would happen if everyone asked for their physical gold at once.

Again, we don’t know that there is any merit to these rumors, but sometimes it is better to be safe than sorry.

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