Five Things BusinessWeek Didn’t Tell You About Commodity ETFs

by on July 29, 2010 | ETFs Mentioned:

As a long-time subscriber to BusinessWeek, I generally enjoy their content and find their stories both informative and interesting. However, last week’s cover story entitled “Amber Waves of Pain” was unlike anything I had ever read by the company before. On the cover, the weekly magazine stated three times “Do Not Buy Commodity ETFs” and then encouraged subscribers to read more about “America’s Worst Investment” inside the issue. Needless to say, I was intrigued to see how a the magazine could make such a blanket statement over such a large segment of the market which by BusinessWeek’s own estimation has seen $277 billion in inflows by the end of last year. Admittedly, the magazine made a pretty good case of the problems which some of the largest futures-based commodity funds deal with. The article started by highlighting several issues which investors have become very familiar with in recent years such as pre-rolling and contango. However, some could argue that the magazine took the impact of commodity ETFs to the extreme, indirectly blaming the funds for a rise in wheat prices which has led to higher costs for baked goods, to higher fuel costs which has led to checked baggage fees for airlines. After suggesting that commodity ETF investors are partly to blame for these higher prices, the article went on to suggest that commodity ETFs in general are a horrible investment decision. “You walk into a casino, you expect to lose money,” says Greg Forero, former director of commodities trading at UBS. “It’s the same with these products. You’re playing a game with a very high rake, a very high house advantage, and you’re not the house.”

Due to this, many investors will likely come away from the article thinking that all commodity ETFs are essentially the same and that they all suffer similar issues which are likely to cripple long-term returns. However, this could not be further from the truth; commodity ETFs represent one of the most diverse market segments available to investors today. Below, we profile several issues and commodity funds that BusinessWeek did not mention in their article in order to show that the title of “America’s Worst Investment” is not as clear cut as some might have you believe [also see Five ETFs Most Investors Don't Understand].

1. What About Normal Backwardation?

The article correctly cites contango as the main factor which has hurt commodity ETF returns over the past few years as prices have fallen as the contract nears maturity. However, the article fails to mention anything about the opposite of the contango phenomenon known as normal backwardation. This trend is when prices rise as time goes on as opposed to declining prices as the contract maturity date approaches in a contango scenario. This trend benefits commodity ETF investors who end up selling at the highest point and buying new contracts at a lower one, giving investors the ability to return more than the spot price may have yielded in a specific time period. While this scenario does not happen as often as contango, it is something that investors need to be aware of nevertheless [also see Ten Commodity ETFs Investors Should About But Most Don't].

2. Not All Commodity ETFs Deal With Contango Issues

Although you might have missed it when reading the BusinessWeek article, some ETFs physically hold the commodities that they are tracking, thus eliminating contango problems entirely. This is most popular in the Precious Metals ETFdb Category where the SPDR Gold Shares Fund (GLD) and the iShares Silver Trust (SLV) dominate their respective markets and have pretty much matched the spot prices of their respective metals so far this year; GLD produced a 6.4% return while gold bullion rose by 4.1%. Meanwhile for silver, SLV is up 4.3% on the year while silver bullion is up 2.7% over the course of 2010, suggesting that not all commodity ETFs are incapable of matching spot prices, especially if they track widely traded commodities that are easy and cheap to store [see How Big Can The Gold ETF Get?].

3. Don’t Forget About ETNs

If investors are looking for funds which traditionally have no tracking error, ETNs are the place to be. These notes are unsecured debt which are offered by the ETN issuer which allows the products to have a few advantages over their ETF cousins, especially in the commodity ETF space. Because ETNs aren’t funds, they don’t rely on equity investments to track their underlying index. Rather, the fund issuer agrees to make a payment to investors upon maturity of the note based upon the price level of the specified asset or index. Due to this structure, ETNs have no tracking error since the cash payment due upon maturity is directly tied to the level of the corresponding index, making them excellent choices for illiquid commodities which investors crave access to. A popular example of this strategy is the iPath Dow Jones-AIG Commodity Index TR ETN (DJP). The fund tracks the Dow Jones-UBS Commodity Index Total Return which follows futures contracts on a diversified basket of commodities traded on U.S. exchanges. The fund, which has a heavy focus on energy and industrial materials, has been extremely popular with investors since its inception; it has amassed more than $2 billion in assets and trades close to 330,000 shares every day [also see Basics Of ETN Investing].

4. Actively Managed Funds

While it is true that investing in commodities can be a dangerous game some investors prefer to use some help when investing in this sector. By using professional managers, investors can avoid the problem that some large funds have of traders pre-rolling their holdings since these actively managed commodity funds do not have a set time that they must roll over to a new contract. Currently, there are not any pure actively managed funds but a few have been in the works and look likely to debut sometime this year. However, for investors seeking a long-short strategy, one option exists; the ELEMENTS S&P CTI ETN (LSC). Although the fund remains very illiquid, with just 70,000 shares traded in an average day, it could offer decent exposure for investors who seek commodity exposure but are worried about some of the issues that BusinessWeek highlighted. The fund tracks the S&P Commodity Trends Indicator-Total Return which is designed to apply a long/short strategy to six commodity sectors comprised of 16 traditional, physical commodity futures contracts . The Index Components are grouped into six sectors and each sector, except the energy sector and softs sector, is represented on either a long or short basis. Despite the fund’s novel strategy it has sunk so far in 2010; producing a loss of 20.7% since the beginning of the year.

5. Leverage

Throughout the article, BusinessWeek discusses how Wall Street “had transformed the reputation of commodities from a hyper-volatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation.” This quote misses the main reason why commodities were so volatile and could ‘steal your shirt’; leverage. Some commodity futures contracts only require 10% of the total contract to be put up on margin, however, the vast majority of the commodity ETFs available to investors do not employ such strategies. When you are using 90% of someone else’s money it is clearly speculating but to say that any buying of commodities is speculation seems somewhat inaccurate.

The article went on to say that “people who would never think of buying a tanker of crude or a silo of wheat could now put both commodities in their 401(k)s. Suddenly everybody was a speculator.” This argument sounds like a similar one that was made about Currency ETFs, however, most forget that much like in commodities, forex traders use extreme amounts of leverage to the tune of 100:1 in some markets. However, ETFs do not apply such strategies, in either commodity or currency funds, a factor which takes out a substantial portion of the risk. This makes it very unlikely that the funds will lose a large portion of their investment in a short period of time, instead, these funds provide a valuable diversifying agent which is often uncorrelated or inversely correlated to broad equity markets [see Do Leveraged ETFs Have A Place In Client Portfolios?].

Worst Investment In America?

Commodity ETF investing is full of risk and there are various types of funds which employ countless strategies in order to offer investors exposure to this asset class. However, to say that all commodity ETFs are terrible ideas because a few may have become easy pray for small traders, is disingenuous to say the least, especially considering the pathetic returns of most other asset classes over the past decade. One recent report summed things up pretty well when it wrote “In addition to offering high returns, the historical risk of an investment in commodity futures has been relatively low – especially if evaluated in terms of its contribution to a portfolio of stocks and bonds. A diversified investment in commodity futures has slightly lower risk than stocks – as measured by standard deviation. And because the distribution of commodity returns is positively skewed relative to equity returns, commodity futures have less downside risk.” So remember that although they can be risky, commodity ETFs can be a valuable tool for investors no matter what the naysayers may tell you.

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Disclosure: Eric is long silver bullion.