Do you what to know what are Commodity ETFs and ETNs and how to use them to trade in the futures market? If so, read all about them below.

What are Commodity ETFs?

Commodity ETFs (exchange traded funds) attempt to track the price of a single commodity, such as gold or oil, or a basket of commodities by holding the actual commodity in storage, or by purchasing futures contracts.

Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.

What are Commodity ETNs?

Commodity ETNs (exchange traded notes) are non-interest paying debt instruments whose price fluctuates (by contractual commitment) with an underlying commodities index. Because they are debt obligations, ETNs are subject to the solvency of the issuer.

Why & How To Use Them

Commodities are a separate asset class from stocks and bonds, so they provide extra diversification in a portfolio.

The case for commodities: The industrialization of the China and India and the integration of Russia and Eastern Europe into the global economy are boosting demand for commodities, driving up prices. Many people believe that this will result in a long term uptrend ('super cycle') in commodity prices.

The case against commodities: In contrast to stocks and bonds, commodities are not income generating. So ownership of commodities, including via ETFs or ETNs, is a pure bet on prices. And the expenses charged by the ETF and ETN providers and in the cost of storing hard assets or trading futures eat away at the underlying value of the fund.

Commodity ETFs and ETNs can also be used as a hedge. For example, if you consume a large amount of gasoline and heating fuel and are concerned about the impact on your income of a rise in oil and gas prices, buying an oil and gas ETF can help offset your exposure.

What to Look Out For

Commodities ETFs that use futures have diverged significantly from the price of the hard commodities themselves. ETNs, in contrast, track the price of the commodity closely. See the articles in the Further Reading section below.

There are dramatic differences in structure of these ETFs and ETNs, even for the same commodities, leading to potential differences in performance and tax treatment.

ETFs and ETNs are treated differently for taxation purposes. Current opinion is that all gains on ETNs held for longer than one year are treated as long-term capital gains, whereas an investor owning a futures-based ETF is taxed on any capital gains on the underlying futures held by the fund using the taxation convention for futures, ie. at a hybrid rate of 60 per cent long-term, 40 per cent short-term each year on all gains, even if the investor doesn't sell the fund.