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December 21, 2012 at 07:00 PM
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.
