As an asset class, commodities have always been like Rodney Dangerfield; they can’t get any respect. For years, they’ve lagged behind stocks and bonds in terms of adoption rate by the investing public.
Investing in the commodities market has been difficult and expensive for most investors. Traditionally, commodity investing was done through futures contracts, master-limited partnerships or by purchasing physical precious metals. But the tide has changed.
A wave of both diversified and single commodity ETPs have launched over the past nine years. How can financial advisors make the best choices for their clients when adding commodities exposure?
Commodity Equity ETPs
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Investing in stocks closely tied to the performance of commodities is one way to obtain commodities exposure.
For instance, oil and gas stocks (OIH) will generally follow the price of crude oil along with other energy products like gasoline and natural gas. Instead of making a bet on the price of the energy commodities, energy ETFs like OIH or IYE allow investors to participate by owning stocks closely tied to their performance.
One drawback of most commodity equity sectors is their tendency to be overly concentrated. One good solution is a diversified ETF like the SPDR S&P Global Natural Resources ETF (GNR). The fund takes a broader approach, by owning 90 global stocks within various commodity sectors like agriculture, energy, and mining. GNR charges a modest annual expense ratio of 0.40%.
Finally, the correlation between commodity equity ETFs and commodities themselves is rarely perfect. This is another potential caveat. One example is how the Market Vectors Gold Miners ETF (GDX) declined 16% in 2011 while gold prices gained around 10%. Although correlation discrepancies do at times occur, they aren’t indefinite.
Futures Based ETPs
Another way to get commodities exposure is through futures based ETPs. These types of products trade in and out of futures contracts on commodities.
One ETP that’s a good candidate as a core commodities position is the GreenHaven Continuous Commodity Index Fund (GCC). The fund avoids distortions in its holdings by equal weighting and index of 17 different commodities. Because of its equal weighting approach, GCC offers significant coverage to grains, livestock and soft commodities and a lower energy weighting versus competing funds. In addition, GCC is rebalanced every day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.
For more concentrated plays, PowerShares and Deutsche Bank manage a menu of commodity sector funds linked to agriculture (DBA), energy (DBE), precious metals (DBP) and base metals (DBB).
The PowerShares DB funds employ a technique called “optimum yield,” which aims to minimize the effects of negative roll yield when markets are in contango and to maximize the effects of positive roll yield when markets are in backwardation. The funds enter into long exchange-traded commodity futures positions and generate interest income through short-term U.S. Treasuries held as collateral for the futures contracts they own.
Drawbacks to commodity ETPs using futures contracts are index tracking error and contango. The latter condition occurs when the price of forward or futures contracts are trading above the expected spot price at the contract’s maturity.
Physical Commodity ETPs