From the May 2014 issue of Research Magazine • Subscribe!

The Case for Commodities

The song “Physical” was a 1981 hit by Olivia Newton-John and it conjures up the yearning that some investors have for hard or physical assets. Aside from other tangible property like real estate or collectibles, commodities play an important role in a diversified portfolio.

Unfortunately, most people aren't farmers and don't have adequate storage space for 300 bushels of corn or a herd of cattle. Perhaps, that's why so many individual investors own little to no commodities inside their portfolios. And that's really the value proposition of commodity-based ETPs: to deliver affordable market exposure to an important asset class that investors would otherwise miss.

Hedging Inflation

One of the principal arguments for owning commodities is to provide defense against a loss of purchasing power or inflation. But are commodities still a good bet against the wrath of inflationary forces? It depends.

“Some commodities are better hedges than others and some are better hedges during different parts of the inflation cycle,” said Daryl Montgomery, author of Inflation Smart: Profitable Investing When Money Devalues. “Gold and silver are your best overall hedges whereas industrial metals, such as copper, lead, nickel, tin and zinc are good when inflation has revved up the economy, but not later on when it starts to take its toll on economic growth and turns into stagflation,” he adds.

Montgomery notes the more inflationary the environment, the better commodities perform. He points to how commodity prices bottomed in 1998 and have been on an upswing ever since.

As for the claims by the U.S., U.K. and EU governments that there is no inflation, Montgomery says the inflation proof is everywhere, “all you have to do is go shopping.”

Underneath the Hood

Commodity ETPs can generally be classified into three groupings; broad baskets, sector baskets and single baskets. Unlike stock and bond ETFs, which are structured as investment companies under the Investment Company Act of 1940, commodity-based ETFs are typically organized as partnerships, trusts or ETNs.

Although the ETN structure offers greater tax-efficiency compared to a partnership or trust, there are drawbacks. Since ETNs are unsecured debt, investors must bear the credit risk of the issuing company. Worst case scenario, the ETN backer goes bankrupt and the notes become worthless, as occurred with Lehman Brothers Opta ETNs.

Funds or ETNs that hold commodities futures replace expiring contracts with new futures contracts that are often more expensive, which subjects them to “contango.” The unfortunate effect of contango is performance drag. The opposite market condition is “backwardation,” where the price of a futures contract is trading below its expected spot price at the contract's maturity. Backwardation can boost commodity returns.

Broad Baskets

The $5.6 billion PowerShares DB Commodity Index Trading Fund (DBC) and the $1.6 billion Path Dow Jones-UBS Commodity Index Total Return ETN (DJP) are among the largest broadly diversified U.S.-listed commodity ETPs.

“I prefer DJP because you avoid the tax complications of a K-1 from some of the more well-known ETF competitors such as DBC,” said David Fabian, managing partner at FMD Capital Management in Irvine, Calif. “Both funds provide similar exposure to futures contracts that track natural gas, gold, crude oil, copper and soft commodities as well.”

Another choice is the Greenhaven Continuous Commodities Fund (GCC), which avoids concentrating too much of its portfolio exposure on a single or group of commodities by equal weighting 17 different commodities and rebalancing.

“Equal weighting provides more diversification than being overweight in one sector like energy or precious metals. It's the same reason why an investor seeking broad equity exposure might buy an ETF tracking the S&P500 vs. buying one that tracks only health-care companies,” said Ashmead Pringle, president, GreenHaven Commodity Services.

Sector Baskets

Sector basket ETPs differ from broad commodity baskets because they concentrate their exposure in a specific segment of the commodities market.

The iPath ETNs, for instance, offer 14 ETNs linked to key commodity sectors like agriculture (DIRT), energy (ONG), industrial metals (JJM) and livestock (LSTK). Seven of these iPath commodity sector ETPs are sub-indexes carved into pieces derived from the Dow Jones-UBS Commodity Index Total Return.

The iPath Dow Jones-UBS Industrial Metals Subindex Total Return ETN (JJM) is among these seven commodity carve-outs or sub-indexes of the much broader index, the Dow Jones-UBS Commodity Index Total Return.

JJM's underlying index is composed of four futures contracts on industrial metals, three of which (aluminum, nickel and zinc) are traded on the London Metal Exchange and the other of which (copper) is traded on the COMEX division of the New York Mercantile Exchange.

For advisors who want core exposure to precious metals, the ETFS Physical PM Basket Shares (GLTR) is a good choice because it owns gold, silver, platinum and palladium. For an annual fee of 0.60%, you’re relieved of trying to guess which metal will outperform.

For the strategic advisor who wants to make a short-term macroeconomic bet or demand/supply based trade, sector basket ETPs are a convenient and affordable tool. The yearly fee on most of iPath's commodity sector ETPs is less than 1%.

Single Baskets

In contrast to the equity ETF market, where broadly diversified funds have the most assets, single basket commodity ETPs dominate their diversified counterparts.

With around $33 billion in assets, the SPDR Gold Shares (GLD) is the world's largest commodity ETP and its singular focus is to track the ups and downs of gold. Each share of GLD is designed to represent 1/10 the ounce price of gold bullion.

The United States Commodities Funds ETPs are mainly focused on the energy market via products like the U.S. Gas fund (UGA) and the U.S. Oil Fund (USO), which has $600 million in assets.

Teucrium offers commodity ETPs linked to corn (CORN), crude oil (CRUD), natural gas (NAGS), soybean (SOYB), sugar (CANE) and wheat (WEAT). Annual expense ratios range from 0.55% to 2.25%.

Summary

Over the past three years, commodities have underperformed relative to stocks and bonds. This has been particularly true of precious metals, which enjoyed a ferocious decade-long rally but began to slump in 2011. But long-term bull markets don't go straight up. Gold lost 47% of its value from late 1974 to mid-1976, but then rallied 800%.

Whether you decide to use broadly diversified commodity ETPs or more narrowly focused ones will largely depend on your investment strategy and client's goals. Even if you don't believe they offer good inflation protection, commodities are a great diversifier.

Commodity returns have historically been about the same as equities, but with a low or negative correlation to both stocks and bonds. According to Modern Portfolio Theory, adding this type of asset class to a portfolio of stocks and bonds improves its return and reduces its volatility—both good things.

“Most investors are likely underweight exposure to commodities which can provide non-correlated returns in a diversified portfolio,” adds Fabian.

Although buying a farm is still out of the question for most people, they don't need to. Commodity ETPs offer convenience, intraday liquidity and affordable costs with no planting and watering required.

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