Commodity ETFs Explained Simply

Think about the last time you bought gold. You probably walked into a jeweller, haggled over making charges, worried about purity, and then found a safe place to store it. Now imagine if you could buy gold or silver, or crude oil as easily as buying a share of Reliance or TCS on your trading app. That is essentially what a Commodity ETFs lets you do.

What Is a Commodity ETF?

A Commodity ETFs (Exchange-Traded Fund) is a fund that tracks the price of a commodity or a basket of commodities. It trades on a stock exchange, just like any regular stock. So when you buy a unit of a Gold ETF, you are not buying physical gold bars. You are buying a financial instrument whose value moves in line with gold prices.

The idea is simple. You get exposure to commodity prices without the headache of physical storage, purity checks, or insurance. And because it trades on an exchange, you can buy and sell it during market hours with a click.

How Do Commodity ETFs Work?

There are broadly two ways a Commodity ETF can be structured:

1. Physical-backed ETFs: These funds actually hold the physical commodity. Gold ETFs in India, for example, are backed by 99.5% pure gold stored in vaults. When you buy a unit, the fund house buys an equivalent quantity of gold and keeps it safely. The price of your ETF unit moves almost exactly with the price of gold. This is the most common structure in India, especially for precious metals.

2. Futures-based ETFs: These funds do not hold the actual commodity. Instead, they invest in futures contracts agreements to buy or sell a commodity at a fixed price on a future date. This structure is more common internationally for commodities like crude oil or natural gas. In India, SEBI (Securities and Exchange Board of India) has been gradually opening up this space, but physical-backed gold and silver ETFs remain the most popular.

Think of it like this: a physical-backed ETF is like owning a flat. You have the actual asset. A futures-based ETF is more like a booking agreement for an under-construction flat. You have a claim on the asset, but you do not hold it yet.

Why Should You Care About Commodity ETFs?

If your entire portfolio is in equities and fixed deposits, you are putting all your eggs in two baskets. Commodities behave differently from stocks and bonds. And that is exactly why they matter.

1. Diversification that actually works: Gold, for instance, tends to do well when equity markets are nervous. During the 2020 market crash, while the Nifty 50 fell sharply, gold prices rallied. Having some allocation to commodities can reduce the overall volatility of your portfolio.

2. A hedge against inflation: When prices of everyday goods rise, the value of commodities usually rises too. If petrol, dal, and cooking oil are getting expensive, the underlying commodities are also going up. Owning commodity ETFs gives you a way to stay on the right side of that price movement.

3. Convenience and low cost: Buying physical gold means dealing with making charges, storage, and purity concerns. A Gold ETF eliminates all of that. The expense ratios are typically low often between 0.5% and 1% per annum. And you can start with as little as one unit, which could be worth just a few hundred rupees.

4. Liquidity: Since commodity ETFs trade on the stock exchange, you can buy and sell them during trading hours at the prevailing market price. Compare this with selling physical gold, which involves finding a buyer and often accepting a discount. The ETF route is far more efficient.

What Are Your Options in India?

The Indian commodity ETF market has grown steadily, though it is still more limited than what you would find in the US or Europe.

Gold ETFs are the most established category. Multiple fund houses Nippon, HDFC, SBI, ICICI, Kotak, and others offer Gold ETFs. These are backed by physical gold and track domestic gold prices closely. They have been around since 2007 and are a well-tested product.

Silver ETFs were introduced more recently, around 2022. They work on a similar principle as Gold ETFs but track silver prices. Silver is interesting because it has both investment demand and industrial demand it is used in electronics, solar panels, and electric vehicles. So silver prices can be influenced by factors beyond just investor sentiment.

For other commodities like crude oil or agricultural products, Indian investors currently have limited direct ETF options. You could look at international ETFs through the Liberalised Remittance Scheme (LRS), or consider commodity mutual funds that invest in shares of commodity-producing companies.

Things to Watch Out For

Commodity ETFs are useful, but they are not without their quirks.

1. Tracking error: The ETF price should ideally move in lockstep with the commodity price. But in practice, there is always a small gap due to fund expenses and cash holdings. This gap is called the tracking error. A lower tracking error means the ETF is doing a better job of mirroring the commodity price. Always check this before investing.

2. Liquidity on the exchange: Not all commodity ETFs are equally liquid. Some may have low trading volumes, which means the difference between the buying price and the selling price (called the bid-ask spread) can be wide. Stick to ETFs with healthy daily trading volumes.

3. Tax treatment: The taxation of commodity ETFs has evolved over the years. As of the latest rules, Gold and Silver ETFs held for more than 12 months attract long-term capital gains tax at 12.5%. For shorter holding periods, gains are taxed at your income tax slab rate. Always verify the current tax rules, as these tend to change with every Budget.

4. No income generation: Unlike equities, which can pay dividends, or bonds, which pay interest, commodities do not generate any income. Gold sitting in a vault does not pay you anything. Your return comes entirely from price appreciation. So commodity ETFs are best suited for wealth preservation and diversification, not for generating regular cash flows.

How Much Should You Allocate to Commodity ETFs?

Wealth managers usually recommend 5–15% portfolio allocation to commodities, mainly Gold ETFs. A 10% gold allocation can reduce volatility during market stress, acting as a stabilizer.

Final Thoughts

Commodity ETFs make it easy for Indian investors to gain exposure to gold, silver, and other real assets without the downsides of physical ownership. They’re affordable, liquid, and offer real diversification benefits.
Start small pick a trusted Gold ETF, check its expense ratio and trading volume, and gradually build your commodity allocation as part of a balanced investment plan.

To Sum Up

Commodity ETFs are one of the simplest ways to add commodities to your investment portfolio. They give you exposure to real assets like gold and silver without the hassle of physical ownership. They trade like stocks, cost less than buying physical commodities, and bring genuine diversification to a portfolio that might otherwise be too dependent on equities.

If you have not explored this space yet, start by looking at Gold ETFs from established fund houses. Check the expense ratio, tracking error, and daily trading volume before picking one. Buy a few units to begin with, and once you are comfortable, gradually increase your allocation based on your financial goals.