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December 21, 2012

Making Sense of Commodity ETFs

Over the past decade, the emergence of new ETFs and other exchange-traded products (ETPs) has effectively democratized access to certain asset classes that had previously been out of reach for many non-institutional investors. Today, in addition to traditional equity index ETFs, investors can gain exposure to commodities, foreign currencies, fixed-income securities and a growing number of more sophisticated investment strategies. Along with the benefits of having more options from which to choose comes a renewed responsibility for investment advisors to understand the strategy by which an ETP provides exposure to a given asset class, since different strategies, even within the same asset class, may provide vastly different results. This is particularly apparent when considering commodity-related ETPs, for which a look under the hood at two different approaches serves to illustrate this point.

Commodity Futures-Related ETPs

One popular approach employed by various ETPs is to systematically maintain a long position in the near-month futures contract for a specific commodity or basket of commodities. This provides a relatively close proxy for short-term spot price fluctuations, to which near-month futures contracts are highly sensitive. The challenge faced by ETPs that employ rolling near-month futures contracts is observed when futures contracts for later months are more expensive than shorter-dated contracts. This condition, referred to as “contango,” is not unusual as later-month contracts are often more expensive than the near-month contract, reflecting the expected storage costs for that commodity as well as interest rates.

However, for longer-term investors in a commodity ETP, contango may be problematic since the ETP systematically realizes a loss of capital each time it rolls long exposure from a near-month futures contract to a more expensive later-month futures contract. Over longer periods of time, this capital erosion may cause the ETP to significantly underperform the spot price.

Commodity-Related Equity ETPs

ETPs that invest in equities related to specific commodities are another alternative for investors to gain indirect commodity exposure. Because a large proportion of a company’s cost for producing a commodity is fixed, the variable price it receives is an important driver for its earnings.

Of course, commodity spot price movements are not the only factor that impacts a related company’s earnings. Commodity producers often seek to smooth out the variability of spot price movements by selling future production in the commodity futures market. Additionally, many producers can temporarily shift production to other commodities that may be more profitable in the short term.

Investment Theses and ETPs

One of the most important questions investors should consider when evaluating commodity ETPs is how well each matches up with his or her investment thesis. For example, an investor interested in speculating on the potential for short-term price gains for natural gas during hurricane season, due to potential storm-induced production shutdowns in the Gulf of Mexico, may be well-served by choosing a natural gas futures-related ETP. Such an ETP will generally be more sensitive to short-term natural gas price movements than an ETF that invests in natural gas-related equities would be.

On the other hand, an investor who is more interested in the long-term case for the natural gas industry may find an ETP that invests in natural gas-related equities more appropriate. While both types of ETPs may benefit from increasing prices, natural gas companies may operate quite profitably even when prices are stable.

In general, there are few instances of good ETPs versus bad ETPs. In sifting through the ever-expanding universe of ETPs, investors are best served by inquiring which ETP is bested suited to achieve their objectives.

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