The Best Way To Gain Commodity Exposure In Your Portfolio

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Includes: AMLP, AMZA, BAR, COMG, GLD, IAU, MLPA, PDBC, SGOL, SLV, USAI, ZMLP
by: Derek Heckman
Summary

Due to the poor performance of the author's investment in an MLP ETF, he is reexamining the commodity ETF universe to find suitable alternatives.

MLP ETFs have high expense ratios and must pay corporate taxes, yet they have a high distribution yield.

Asset-backed ETFs provide inexpensive asset to precious metals like gold and silver, yet the asset earns no income and must be sold to pay the fund's expenses.

Futures-based commodities ETFs are few in number and don't hold the actual commodity; however, they are diversified and seem to be the best option for commodity exposure.

Investment Thesis

Commodities contribute diversification and can significantly increase a portfolio's return. However, the menu of commodity funds is colorful, the funds themselves can be vastly different from each other, and not all of them invest in the actual commodity itself. I tend to prefer low-cost, passively-managed index ETFs for my investment portfolio. But with the large menu of commodity ETFs available, what is the best way to gain exposure to this asset class? After some preliminary research, I have found several commodity ETFs that would be excellent additions to a well-diversified portfolio. However, the best option depends on your investing goals and personal preferences. I will give you some options for serious consideration and explain why I would stay far away from one category in particular.

My Own Commodity ETF Holdings

For commodities exposure in my own portfolio, I currently hold the InfraCap MLP ETF (AMZA). In a recently published article here on Seeking Alpha, I reviewed the merits of AMZA, discussed why I originally purchased it, and opened myself up for some criticism by admitting that I was attracted by AMZA's high yield and added positions to an investment that didn't actually meet my requirements. This article is a continuation of my discussion about AMZA. Now that I have determined that this was not an appropriate investment for me, what is an appropriate ETF investment for me to gain exposure to commodities?

First: MLP ETFs

Since I already have a position in AMZA, I will begin with MLP (Master Limited Partnership) ETFs. These funds invest in MLPs and seek a high level of distributions from the pass-through of oil and gas income, as well as capital appreciation of the related pipeline infrastructure. As discussed in my AMZA article, this asset class is currently out of favor and several MLP ETFs are now seeing lows.

To identify these funds, I used the excellent screener at ETF.com, which returned a list of 11 MLP ETFs; ETNs were excluded. Since I already have equity exposure in my portfolio, I also excluded all "infrastructure" ETFs because they hold corporate stock, and instead focused on funds investing exclusively in MLPs. The resulting 6 funds are shown below:

Source: Author

Except for MLPA (Global X MLP ETF), the expense ratio tends to increase as the fund's size increases. As an index-focused investor myself, both MLPA and the Direxion Zacks MLP High Income Shares ETF (ZMLP) would warrant more in-depth research, especially for ZMLP, whose fund size of about $51 million is below my target size for ETF holdings. Additionally, the tax classification of these funds is troubling (which I discussed in a separate article focused exclusively on MLP ETFs). Because they are classified as corporations, MLP ETFs must pay corporate income tax on their earnings. On a related note, as so many of these funds are currently in the red, many of the distributions that shareholders receive are classified as return of capital (ROC), which aren't really dividends at all. Some investors may find ROC beneficial, but these types of distributions are not appropriate for my portfolio: my focus is on steady asset growth and stable dividend distributions from earned income.

Pros:

  • Access to commodities through oil and gas pipelines and the associated production income.
  • All of these funds are diversified, reducing the risk of investing in only one MLP.
  • HIGH level of distributions.
  • It may be a good time to buy, as several funds in this asset class have suffered falling market prices.

Cons:

  • With the exception of MLPA and ZMLP, these funds generally have high expense ratios.
  • Liable for corporate income taxes, which can eat into your return.
  • I can't repeat this enough: ROC is not earned income!

Best Commodity ETF for MLPs: I do NOT recommend this category for commodity exposure. However, if you must, I would pick the biggest and most liquid fund in this group which is AMLP (ALPS Alerian MLP ETF).

Second: The Rest of the Commodity ETF Universe

With MLP funds out of the way, we now turn our attention to the other possible commodity ETF investment options. Again using the screener at ETF.com, I selected the "commodities" asset class, excluded all ETNs, and set a max expense ratio of 0.9%, which resulted in a list of 41 funds. Of these 41, I included:

  • The 4 largest gold funds (a popular precious metal).
  • The largest silver fund (for comparison to gold).
  • All other futures-based oil and gas or commodity index funds (excluding sector-based funds, which hold corporate stocks).

This leaves us with a total of 19 funds (5 gold and silver ETFs and 14 oil and gas/commodity ETFs):

Source: Author

Note: Readers may access this chart in a read-only Google Sheets document by clicking on the blue link.

Asset-Backed Precious Metals ETFs

Of the five precious metals ETFs from the list above, any one of these can be used by the investor to gain access to the underlying physical asset; in this case, either gold or silver. Each of these funds operates in a similar manner: they all hold the physical asset (compared to funds utilizing futures-based strategies, discussed next), the funds pay no dividends because they only hold non-productive physical assets, they sell portions of the physical asset to pay fund expenses, and generally the only fund expenses are security/storage and management/accounting fees. In general, these funds only receive cash inflows from their holdings of U.S. government bonds, from investor purchases, and through sales of the asset. These funds are also dependent upon rising market values to keep them solvent. In the case of both GLD (SPDR Gold Trust ETF) and SLV (iShares Silver Trust ETF), this is not a pressing concern because their assets are in the billions.

Pros:

  • Easy and inexpensive access to precious metals through a tradeable ETF.
  • No need to secure or maintain the underlying physical asset.
  • Precious metals, in general, are an excellent hedge against inflation and can be uncorrelated to equities.

Cons:

  • These funds receive no income and must sell the underlying asset to pay fund expenses.
  • Not diversified: Limited to the single precious metal that the fund holds.

If your goal is direct access to gold or silver, then any of these funds would be appropriate for you (with some additional research and due diligence). For gold, I would recommend IAU (iShares Gold Trust ETF) over GLD due to the lower expense ratio. Aberdeen Standard Physical Swiss Gold Shares ETF (SGOL) is also a promising gold ETF option; however, it is one of the smaller funds in this group. SLV, as previously noted, is the largest physical silver ETF out there and most likely your best bet for investing in silver.

Despite the positives of these physical asset ETFs, for my own portfolio, these funds are too focused on one individual asset and I would not personally choose these asset-backed ETFs as an investment. This leads us to the next and final commodity ETF category: futures-based funds.

Futures-Based Commodities ETFs

Instead of investing in the actual physical assets (oil and gas pipelines/infrastructure for MLPs and gold bullion for precious metals ETFs), this type of ETF gains exposure to commodities through the use of futures. To use an example, let's take a look at the largest ETF in this category: Invesco DB Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC).

Per the fund's website, PDBC invests in "commodity-linked futures and other financial instruments that provide economic exposure to a diverse group of the world's most heavily traded commodities." Some of these commodities include gasoline, New York Harbor ULSD (Ultra-Low Sulfur Diesel), Brent crude oil, gold, and sugar. This addresses my earlier point about the oil-only, gold-only, and silver-only funds not being diversified: you can access those asset types through a futures-based ETF like PDBC.

These funds generally have a low distribution yield, fund their cash needs through interest income derived from investments in U.S. government bonds, and earn the majority of their income from gains and losses on futures contracts, swap agreements, and related activities. One important thing to note: As you can see on the chart, Yahoo! Finance shows COMG's (GraniteShares S&P GSCI Commodity Broad Strategy No K-1 ETF) distribution yield as 18.89%. This appeared irregular to me so I reviewed a few of COMG's financial reports. The fund distributed around $1.1M of their 2017 and 2018 income within the past year on only 252K shares outstanding, which is the source of the seemingly-high dividend yield. However, I would not count on that level of dividends continuing on into the future.

Pros:

  • Rivals the low expense ratios of several of the asset-backed ETFs previously mentioned.
  • Well-diversified; provides access to a variety of different commodity types (including gold, silver, oil, and natural gas).
  • Simplified tax reporting, as many of these ETFs are classified so that they can avoid K-1 reporting.

Cons:

  • Doesn't own the actual asset, but uses futures instead.
  • Lack of well-established, investable ETFs.

Best Futures-Based Commodity ETF: PDBC is your best bet for broad-based exposure to commodities through futures.

Lastly: Honorable Mentions

The American Energy Independence ETF (USAI), though not included in the discussion of MLPs above, has made a concerted effort to remain classified as a Regulated Investment Company (RIC) and avoid corporate taxation. It does this by limiting its MLP holdings to below 25% of the portfolio and mostly holds energy infrastructure-related equities. Those investors in search of MLP and energy infrastructure exposure may want to consider USAI and conduct research on its fundamentals.

GraniteShares Gold Trust ETF (BAR) was left out of the physical asset-backed section because it was the fifth-largest gold ETF in the pack. However, despite its relative newness and small asset size, it may still be a viable investment option.

Summary

Unfortunately, the high expense ratios and classification of MLP ETF distributions as ROC exclude them as an acceptable investment in my portfolio. As I admitted in my article about AMZA, I fell for the high distribution yield last year; however, fool me once...

Out of the three commodity ETF categories reviewed (MLPs, precious metals-backed, and futures-based), futures-backed ETFs seem to be the best fit for my investing goals. My preference is for funds to own the actual asset in which it is investing, rather than futures. However, because of the downsides of MLP and precious metals ETFs, futures-based commodity ETFs appear to be the best option to access this asset class.

Disclosure: I am/we are long AMZA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.