Some ETFs Boom by Getting Physical

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"Physically backed funds can sidestep contango. . ."

The investing hordes are going in for hoarding, a concept that has appealed to military strategists, legendary value investor Benjamin Graham and squirrels.

But as fund companies create more products that stockpile raw materials, emerging challenges suggest the idea may come up short as an investment strategy.

Since 2004, investors have socked billions into U.S. ETFs backed by raw materials rather than by the usual futures contracts or other paper proxies for physical commodities. As investors buy shares in the funds, the funds typically acquire more material. The value of the shares rises and falls with the actual commodity.

Thus far, these "physically backed" funds have focused largely on precious metals—the largest holds gold but others hold silver, platinum and palladium—and have appealed to investors who have a "greater degree of comfort" with hard assets than stocks, bonds, future, etc.

As of the end of last year, nine physically backed U.S.-based ETFs together had amassed $77.6B of assets, according to fund-tracking firm IndexUniverse, compared with $24B for futures-backed commodity ETFs.

Physically backed funds are attractive to some because they avoid a problem with futures-based commodities investing that has hurt returns—the expense of selling expiring monthly contracts, and then buying new ones. The impact can be large because new contracts frequently have been more expensive in recent years—a phenomenon known as contango that reflects both the carrying costs and expectations of future supply and demand.

By holding the actual goods, the physically backed funds can sidestep the contango and sidle closer to what many investors want—returns that move in tandem with price changes in the underlying material.

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