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Commodities: Avoid or Add?

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If there’s one asset class to which most portfolios lack exposure, it’s probably commodities. It’s also an area whose recent performance has been so ugly, some investors have completely abandoned ship.

Over the past five years, broadly diversified commodity ETFs have declined around 30% on average while other asset classes like stocks and bonds have risen. Plunging crude oil and precious metals prices have been a damper. Should advisors avoid commodities?

Research interviewed Cooper Anderson, chief financial officer of GreenHaven, about the outlook for the commodities group and how to get affordable exposure to this volatile but important market.

While the Atlanta-based firm is best known for its flagship fund, the $243 million GreenHaven Continuous Commodity Fund (GCC), the commodities focused firm is still adding to its lineup. In February, the firm launched the Greenhaven Coal Fund (TONS) which tracks coal futures.

Why do you think commodities are under-represented in the typical investor’s portfolio?

There are several reasons for this. First, much of the investing public still doesn’t understand the value of adding commodities to a portfolio of traditional asset classes. This value comes from commodities’ historically low correlations with equities and bonds. Secondly, some investors perceive commodity prices as too volatile. However, in many timeframes a basket of commodities that is rebalanced regularly has actually had lower volatility than the S&P 500! It’s the use of high leverage that can really make commodity returns volatile. Third, commodity returns have underperformed other asset classes such as equities for the last several years.

The Greenhaven Continuous Commodity Index Fund (GCC) has a unique approach that makes it very different from competing commodity funds. Tell us more.

GCC tracks the Thomson Reuters Continuous Commodity Index. This index, and thus GCC, are unique for three reasons: (1) It has a much lower allocation to energy commodities at only about 18% than many of the other commodity funds which can range up to 70% in energy; (2) it is rebalanced daily so that each of the 17 commodities in the fund is kept as close to 1/17th of the total as possible, which helps reduce volatility and can add a rebalancing yield; and (3) GCC’s exposure to each commodity is not concentrated in the front month, but is spread across the nearest 6–9 months of the forward curve. This approach of spreading across the futures curve is intended to help to mitigate some of the costs of carrying a long-only futures position over time.

In the past, the CFTC has restricted the amount of futures contracts an ETP can have and it’s caused operational problems for certain ETPs. Is this still an issue?

Position limits can cause issues for commodity futures-based ETPs if the desired allocation to a given commodity is greater than the limit. This is one of the reasons that fees on many commodity ETPs are slightly higher than equity ETPs because even the most successful commodity ETPs can’t achieve the scale and size of some of the larger equity ETFs due to position limits.

The result of reaching a position limit can be that an ETP issuer has to suspend creates, which can cause a fund’s market price to trade above its net asset value. When and if the fund is able to allow creates again, the market price can then converge back to net asset value and investors that purchased over NAV may sustain losses.

The national power grid is roughly 40% coal, 25% natural gas, 20% nuclear power and about 10% renewable sources. How is the move toward clean energy power changing the investment landscape? (Feel free to mention that Tesla’s Model S relies heavily on coal and a TONS tie-in.)

Although recent U.S. environmental regulations have gotten attention, the relatively low price of U.S. natural gas has caused as much or more destruction of domestic coal power demand than the regulations themselves. When and if that reverses, coal prices may rise, offering a way for one to play higher natural gas without the volatility of natural gas futures.

Even with the plant closings and environmental regulations, coal will remain a significant part of U.S. power generation. People tend to forget that some of our exciting newer technologies such as the Tesla Model S have really just transferred the power source from crude oil to electricity, a large part of which is generated by coal-fired plants. In addition, coal continues to help fuel growth in many fast growing economies such as India and China—which are also starting to focus on clean coal technologies.

In more mature economies like Europe, which has an expansive emission trading system in place, coal has maintained a strong foothold—part of this is because natural gas can be 4 to 5x more expensive then what we pay in the U.S. making coal a very competitive, low cost, and plentiful power source. I think the takeaway here is that coal isn’t going away anytime soon!

We created TONS to give investors direct access to this globally important energy source. TONS is the first ETP to offer exposure to coal futures prices. It is passively managed to be long the front calendar quarter of Rotterdam Coal Futures. Since coal represents almost 40% of global energy consumption and is the fastest growing fossil fuel for the last five years, we thought investors might be interested in including coal as a part of their energy allocation or to trade. In a funny way, TONS and Tesla are connected.

Many commodities are priced in U.S. dollars. Would owning commodities be another way to hedge against currency weakness?

Many studies have shown that commodities in general have significant correlations to currency prices. To the extent those correlations hold up they can certainly offer a hedge to someone wanting to protect themselves against a falling dollar or inflation. As your question states, this is simple math in that many commodities are priced in U.S. dollars and so their price will often move in the opposite direction of the currency all else being equal.

How are commodity ETPs taxed and what should financial advisors look for before jumping in?

At the end of each year the commodity ETPs’ futures positions are marked to market and taxed at 60% long term capital gains/losses and 40% short-term capital gains/losses. Any interest income is taxed as ordinary income. If an ETP is treated as a partnership, as TONS and GCC are, then these are passed through to the shareholder via a K-1.

Our K-1s are issued by the end of February so investors have plenty of time before their filing deadline. In a qualified tax-deferred account (i.e., 401[k], IRA, pension, etc.) the K-1 is more of a non-issue. From an investment advisor’s perspective they should understand whether or not an ETP is going to need to an issue a K-1 (it will if it’s a publicly traded partnership) so that their clients will be on the lookout for a K-1 before filing their taxes.


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