With the finish line in sight, 2010 has been a generally solid year for commodities as an asset class; strong demand from emerging markets, a shaky dollar, fears about inflation, and a number of supply issues have conspired to send prices of everything from corn to gold to sugar skyward [see Top Five Commodity ETFs Of 2010]. Despite the impressive performance from a number of different commodities, inflows into commodity ETFs have been light in 2010. After more than $30 billion flowed into commodity ETPs in 2009, inflows through the first ten months totaled only about $10 billion–almost all of which was attributable to physically-backed gold products.
Part of the explanation for the relatively slow weak inflows may be related to frustrations with the performance of certain futures-based products. The underlying holdings of most commodity ETFs are not the actual commodity, but rather futures contracts written on the specified resource (currently, all physically-backed U.S. commodity ETFs hold precious metals–gold, silver, platinum, and palladium). As such, the returns to these products depend not only on changes in the spot price of the commodity, but on the slope of the futures curve as well. When markets are in contango–longer-dated contracts are more expensive than those approaching expiration–returns to a futures-based strategy can lag far behind a hypothetical return on the commodity’s spot price [see How Contango Impacts ETFs].
Earlier this week, we profiled four options for investors concerned about the impact of contango to establish exposure to commodities through ETFs, including the “third generation” ETF from United States Commodity Fund and the Optimum Yield products from PowerShares. Each of these four strategies involved structuring exposure to natural resources and futures contracts in creative ways; below, we add two ideas that involve gaining exposure to commodities through different asset classes.
Commodity-Intensive Equities: Pros And Cons
Gaining commodity exposure through stocks might seem like a strange concept, but there are already billions of dollars invested in ETFs that do just that. The profitability of virtually every public company depends on the prevailing market price for its goods and services, and those whose operations center around extracting and processing raw materials are no different. If Apple is able to charge higher prices for iPads, the company’s bottom line will improve. Similarly, if gold prices rise the outlook for a gold miner should increase, as higher revenues from selling its product (gold) will translate into higher earnings. So a strong correlation will generally exist between the price of a commodity, and the stock prices of companies whose business revolves around extracting or manufacturing (and ultimately selling) that commodity [also see Playing Commodities Through Exploration ETFs].
There are a couple of advantages to playing commodities through equity ETFs. First, the issue of contango becomes irrelevant, since the underlying assets are stocks and not futures contracts. Second, the underlying assets are actually associated with a stream of cash flows; whereas a bar of gold will never pay a coupon and a herd of cattle will never make a dividend payment, stocks of gold miners and agribusiness companies can generate profits and make payments to their shareholders.
There are some potential disadvantages as well. One of the appeals of commodities to many investors is the low correlation of this asset class with stocks and bonds. While there is a strong correlation to the related commodities, at the end of the day there is also a relatively strong correlation to broad stock markets–diminishing one attractive element of commodities as an allocation within a traditional stock-and-bond portfolio.
Currently, there are 25 ETFs in the Commodity Producers Equities ETFdb Category, offering investors a number of options. There are a number of broad-based products that spread exposure across a variety of industries, including:
- Hard Assets Producer ETF (HAP)
- CRB Global Commodity Equity Index Fund (CRBQ)
- IQ Global Resources ETF (GRES)
Playing Commodities…Through Currencies
There’s also an ETF option that allows investors to gain exposure to currencies of commodity-intensive economies; the WisdomTree Dreyfus Commodity Currency Fund (CCX) is an actively-managed product that seeks to deliver returns reflective of money market rates and changes in value relative to the U.S. dollar of certain developed and emerging markets currencies. Historically, currencies of commodity-intensive countries show increased sensitivity to global growth levels; as demand for raw materials produced by that country increases, the currency will tend to appreciate. But during “down” commodity periods, these currencies have historically had a limited downside [read Advanced Currency ETF Investing].
Currently, CCX has exposure to the South African rand, Canadian dollar, Russian ruble, Norwegian krone, Australian dollar, Brazilian real, Chilean peso, and New Zealand dollar–a roughly even split between developed and emerging markets. These countries represent the world’s largest exporters of gold, silver, nickel, natural gas, sugar, zinc, coal, iron ore, aluminum, and livestock, meaning that exposure is spread across a variety of commodity markets (oil-rich Middle East countries aren’t included because their currencies don’t float freely).
Betting on currencies of commodity-producing nations has long been a popular play on foreign exchange desks, as this strategy tends to perform well when commodity prices are climbing and can be an effective hedge against unexpected upticks in inflation as well [see Under The Hood Of CCX].
Plenty Of Options
Investors looking for exposure to commodities through ETFs have no shortage of options, with each maintaining slightly different risk and return profiles. Each of the six strategies outlined has advantages and disadvantages; there is no universally superior way to tap into this asset class. The lesson, as always, is to do your homework and find the tactic that works best with your investment objectives [see the Ten Commandments Of ETF Investing].
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Disclosure: No positions at time of writing.