A lot of people invest in commodity mutual funds and ETFs because of the convenience these funds offer. A large number of investors use these funds as a proxy for holding the commodity itself. After all, how many of you want to hold barrels of oil in your backyard?
If you own a commodity fund and expect that fund to hold the underlying physical asset — this may not always be true. There are different type of Commodity ETFs that track the price of the underlying assets in different ways.
Funds that Own the Physical Assets
If you are buying a commodity fund only because you don’t want to directly own the underlying asset — these type of funds offer you the closest proxy.
Funds that Own Futures Contracts
ETFs like the Power Shares DB Funds don’t own the physical underlying commodity at all. These funds enter into Futures Contracts and create strategies such that the price of the fund behaves in sync with the price of the underlying asset. Normally, such funds track the movement of an underlying Index, which in turn is designed to track the movement of the prices of the underlying asset itself.
These funds hold short term credit instruments and US Treasury units in addition to the futures contracts. Such instruments enable them to earn interest income which can be then used to cover their expenses.
Funds that Own Mining Stocks
Then there are ETFs that hold stocks of companies that deal in the underlying assets. These are funds that own stocks of gold mining companies or steel mills etc. They don’t own any physical asset at all and are purely invested in stocks of the underlying companies.
Exchange Traded Notes
ETNs are often mis-understood to be an equity instrument, these are really debt instruments and depend on the solvency of the bank or financial institution that issues them.
Proxy for Physical Assets
If you are just looking at buying a fund that holds the physical quantity of the underlying asset for you — then you should get into the first category of funds described here.
Personally, those are the only funds that I prefer. Why pay someone else for a futures contract that I myself can enter into and why pay someone else for owning a stock that I can buy directly? As for ETNs, they are not an equity instrument at all, so the question of being a proxy for physical assets is really remote.