A commodity EFT or exchange traded fund, is used to track the price of an individual commodity like silver or gold, or it could also be used to track a basket of commodities, where storage costs could play a factor, or it could buy up futures contracts.
Because commodity futures offer leverage, ETF commodity funds also place extra capital in something like an interest-bearing government bond. That way any dividends paid out can be paid out of that interest from the bonds.
The interest is also used to pay expenses incurred by the commodity ETF.
There is also another debt instrument called a commodity ETN, or exchange traded note, whose price fluctuates with the commodity index it is associated with. There are credit risks with ETNs, which are in effect senior bank notes.
In general, commodity ETFs track commodity production companies; like a mining outfit. Because of that, many factors can contribute to its performance, outside of leverage alone.
Even though we are in a temporary holding pattern for commodity demand, it will resume as soon as the global economy turns around, and then we should see years of significant profits in the overall sector.
This will make all commodity investment very alluring, along with commodity ETFs.
The emerging markets, especially China and India, although including Eastern Europe and Russia, guarantees demand won't subide any time soon, and battles over access to resources will push prices up, as the middle classes in these regions continue to grow.
One thing about commodities that must be kept in mind, is they don't generate income, so prices are the sole purpose for entering into them, including the hedging aspect of commodity prices.
Another important factor is the expenses connected to investing in commodity ETFs. Everything from trading expenses, storage of raw materials and other general charges must be taken into account in the overall picure.
Because most commodity ETFs don't tend to trade as much as regular funds, there could be fewer expenses there, but nonetheless, it has to be watched because it can definitely be the difference between failure and success, depending on the ETFs performance.
As mentioned earlier, like all commodities, a commodity ETF or ETN can offer a hedge against other factors affecting your income, and so if energy prices of some type increase significantly, you can buy into an energy ETF to offset those increase in prices, and hedge against the inflationary pressures.
Finally, whether it's a commodity ETF or ETN, there are very different treatment of taxes on gains, and you do need to consult your accountant to get the whole picture of how your investment will fare if successful.