Investing in Commodities and Futures

Some of the smartest investors realized years ago that commodities and financial futures belonged in their portfolios. Between practitioners and academic researchers, common agreement was reached that commodities and futures investing (CFI) does lower volatility (risk), increase returns and is uncorrelated to the typical asset classes of stocks and bonds. Everyone else became a believer after 2008, when CFI was the only sector left standing. Now that everyone is on board, the debate has shifted to passive versus active management. Can an index of commodities or financial futures deliver the same performance as actively managed accounts? Our research says active outperforms passive by a wide margin, and after all costs are accounted for, too.

CFI, a commonly-used designation, is a bit of a head-scratcher because it encompasses much more than it literally says. “Commodities investing” refers narrowly to assets which come out of the earth and are in physical form, whether an agricultural product, a metal, oil, etc. The “futures investing” part technically only describes a single and specific trading vehicle, a futures contract. While there are futures contracts on many different underlying assets and markets including currencies, bonds/interest rates, and commodities themselves, CFI, in practice, includes many more trading vehicles. For example, these others may include forwards, options, swaps, commodity-related equities and even cash and carry in the physical commodities. In fact, they may be the most diversified of all investment alternatives. Out of over 100 asset classes and markets commonly traded, approximately 65 have enough volume to be considered active and deep and are therefore used the most.

The challenge is how best to achieve CFI exposure and its positive benefits, while minimizing any detriments. Yet, we have all learned, heard and seen the risks, but know little about “how to get the benefits.” What follows could be fairly labeled an exposé of some of the myths, as well as a summarized comparison of alternatives.

Adding CFI Exposure
There are many ways to accomplish CFI exposure, but the first decision is how much money to allocate. In one study, Ibbotson, a notable research firm, calculated that 25% of a diversified portfolio was the optimal historical allocation. However, most investment advisors would say that a better target would be 5% to 15%, depending on the knowledge, time horizon and personal risk tolerance of the investor.

Second, where and with whom should I put my money? And, should I go passive, active or both? A passive or static approach may be rules-based and implemented mechanistically without subjective discretionary judgments made by the manager. Usually, trading is infrequent; most often, the strategy is long (seeking price increases). Some passive funds invest using an index or basket of “stuff,” while waiting for the desired price movement. Active means relying on the manager’s judgment to select which markets, allocation amounts and time period.

Active investing in CFI through your friendly broker means using your own or their advice. However, verifying the broker’s prowess in offering advice may be more than challenging, so that you may be forced to rely on your own expertise. Managed accounts at brokerage firms can work, but are not for the faint of heart because of the margin issues, which expose the investor to the possibility of losing more than the starting capital.

ETFs in CFI
The big sellers of financial services to individual investors have sought simple, broad-based and widely available investment alternatives to tap as many investors as possible for passive investing. The most popular—intensely marketed and providing attractive revenues to the seller—have been exchange-traded funds, the ubiquitous ETFs offered on many different markets, e.g., the U.S. Oil Fund, U.S. Natural Gas Fund. Typically, an ETF buys futures contracts in its designated market hoping for price appreciation.

The challenge has been that many of these ETFs were launched during a time when many futures contracts traded more expensively in the near-term months of expiration and less so as time lengthened (called backwardation). This phenomenon meant that an ETF could passively invest in the desired futures contract and, as it neared expiration, roll the investment forward to the next time period, earning small profits even without upward price movements in the underlying asset or market. Unfortunately, this price pattern can and did reverse. Longer-term futures contracts became more expensive than the shorter-term contracts (called “contango” by traders). When upward price movements were insufficient to offset the negative price spread between the contract being sold and the one being bought, steady losses were experienced. Worse yet, traders pounced on these “known” rolls seeking to capitalize on the ETF’s trading patterns. In order to capitalize on the price movements from these new entrants, Wall Street firms have used storage facilities in unprecedented amounts to take physical delivery as another way to trade against them. Whether due to the trading from others or a flawed product design, many of these ETFs have not accurately tracked the price movements of their underlying asset and market classes.

CFI is growing quickly, stimulating the creative juices of Wall Street and, as a result, its offerings will develop at a rapid pace. Move over Baskin and Robbins, the ETF flavors are many, growing, and evolving in their structures. There are spot funds investing directly in the asset, plus short (inverse), leveraged, equity-based, etc. To combat their flaws, there are new roll strategies, long-dated futures contracts, and more on the drawing boards. The biggest, double digit billions, are the spot or directly investing ETFs in gold and silver. This approach solves problems with tracking error and costs of the future contract rolls, but does incur costs of storage.