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Oil exchange traded funds (ETFs) are grouped under the commodities umbrella for ETF investing. Before oil ETFs became available, the average investor had little access to gain exposure to this asset class or group of securities, because this type of investing was reserved for the largest financial institutions and investors. Oil ETFs changed that, and they provide investors with exposure to the commodities industry in what is largely considered an affordable and streamlined process.
To understand the purpose and composition of an oil ETF, it is helpful for one to know the role of ETFs in the financial markets. An ETF is an investment vehicle whose performance — that is, gains or losses — closely track that of another underlying index. The index is comprised of assets such as equity securities or stocks, bonds or commodities.
An ETF trades, or gains and loses value, at about the same rate as the net asset value, which represents the price per share based on the value of the securities in the index, or the securities that make up the ETF. Oil ETFs, therefore, tracks performance in commodities contracts instead of stocks or bonds, and these contracts are also referred to as futures contracts that trade on a commodity exchange in the region. Investors should be aware of the tax implications of investing in oil ETFs, a structure that will vary depending on where the investment takes place.
Trading activity surrounding an oil ETF is largely tied to the market swings or price fluctuations often tied to commodities investing. In order to capture the price movements or volatility often inherent with these securities, given that oil prices are dependent on supply and demand, investors can choose from two courses of action. They can either bet that an oil ETF will gain in value, which is known as going long, or they can bet that the index fund will decline in value, which is known as shorting the ETF. Typically, shorting ETFs is reserved for sophisticated investors such as hedge fund managers.
In addition to tracking the price of the resource oil in commodities, an oil ETF can also track the underlying value of a group of oil stocks. An oil ETF might track the performance of a group of oil services stocks, which represent drilling or equipment companies that uncover oil and gas from the ground. The index also might track performance in pipeline companies that are responsible for transporting oil through underground pipelines.