Are you considering including or adding more commodity exposure to your portfolio ...well, you're not alone. Over $50 billion is invested in commodity ETPs (ETFs & ETNs), more than $25 billion in broad based commodity mutual funds, and an estimated $1.25 trillion in OTC commodity derivatives. ETPs and mutual funds are the most accessible and offer low cost, liquid, professionally managed exposure to commodities. Commodity ETFs in particular are relatively new on the investment scene but are quickly becoming the commodity investment vehicle of choice. Commodity ETFs come in a wide array of exposures including single commodity, broad based, index tracking, sector specific, long/short/flat, leveraged and actively managed. But before you pick an ETF, you should consider why you are adding commodities in the first place.
It is no coincidence that some of the largest and arguably best investors in Endowments and Foundations, are long term holders of commodities. Commodities have shown to be positively correlated with inflation, the enemy of long term investor value. In periods of rising inflation, the nominal value of commodity prices generally rise. This is in contrast to traditional stocks and bonds that have shown to be negatively correlated to inflation and uncorrelated to commodities. Additionally, Individual commodity contracts are not just uncorrelated to stocks and bonds, they are also uncorrelated to one another. Attributes specific to commodities make them an excellent diversifying asset and adding even a small amount to a portfolio can; protect against unforeseen inflation, lower portfolio volatility, and enhance overall returns. If these are in fact your goals, then we recommend you focus on ETFs with the following structure.
This is rather straight forward as it stems from the old adage "don't put all your eggs in one basket". Diversification, even within a diversifying asset class has benefits. There are three main commodity sectors; agriculture, energy, and metals. Within these sectors resides a multitude of individual commodity contracts. To achieve meaningful diversification, your commodity ETF should have exposure to all three sectors and include contracts with the greatest economic significance within those sectors. We would suggest no less than a dozen individual contracts including crude oil, gold, and corn or wheat.
When Gorton and Rouwenhorst published their seminal work "Facts and Fantasies about Commodity Futures" , they began by constructing an equally-weighted index of commodity futures. This was primarily to "reduce noise inherent in individual commodities" and measure commodity futures as an investment class, allowing comparison to traditional stocks and bonds. Additional studies have been done including a refresher to Facts & Fantasies 10 years later, and they confirm that a broad based, balanced basket of collateralized commodity futures provides; a risk premium slightly below stocks, diversification to a traditional portfolio, and positive correlation to inflation over the long term.
To be certain, balanced does not require a perfectly equal-weighted distribution. In fact as commodity prices fluctuate, weightings will become unbalanced until the next re-balance period. The key here is a majority of the research highlighting the benefits of commodities is based on a generally balanced basket exposure. This is in contrast to many legacy commodity indices that were originally developed as benchmarks. These indices were specifically designed to measure commodity price fluctuations weighted by global production and or consumption value for each individual commodity. This design was likely rooted in capital asset pricing theory (CAPM) which defined a diversified portfolio as one that would contain all assets weighted by their proportion of total market value. The most significant drawback to using a production/consumption weighted index is the heavy allocation and subsequent exposure to the energy sector.
The historical randomness of individual commodity contract returns highlights the need to balance individual exposures. Trading professionals like Commodity Trading Advisors, are well aware of this random behavior of commodity returns, which is why most trade a wide variety of commodity contracts. They are indifferent to which contracts trend higher or lower and profit when trending periods outweigh mean reversion periods. Because they cannot know in advance which contracts are likely to make sustained price moves, they place similar or "balanced" risk parameters on each position. In other words, a position in crude oil will have a roughly equal portfolio risk profile to a position in corn. Other than liquidity, economic significance or value does not factor into their contract selection or risk weighting.
We prefer a passive "smart beta" management style not because it performs better than active management, but for two non-performance reasons. First and foremost, passive management funds generally have lower fee structures. Active managers receive additional compensation in the form of higher fees to provide "alpha" for their clients. We don't disagree that active management is an important source of return for asset classes like hedge funds or CTAs, but likely represents an unnecessary cost for long only commodity exposure. Secondly, if commodity exposure is the goal, you want to be assured your manager is fully exposed when the market moves. Many actively manged ETFs re-balance/reconstitute on a monthly basis which leaves the potential for a significant move prior to the manager being fully invested. Furthermore, in sustained mean reverting periods active management can significantly under perform long only.
This is basically a subset of management style, although a passively managed ETF does not necessarily have to track an index. We prefer an index based ETF for commodity exposure for the transparency of methodology. Index providers generally make available their calculation rules including but not limited to; composition, weightings, roll methods, and re-balance schedule. With an index based exposure, we can be assured the structure matches our investment goals.
Advanced Roll Methodology
To be sure, commodities are not traditional assets. When most of us talk about commodities, we are generally referring to the price of a specific commodity at that point in time. Crude oil is the worlds largest consumed commodity as measured by value, and is quoted as U.S. dollars per barrel. Today a barrel of crude oil (42 liquid gallons) cost about $50. In trader terms, we call this the spot or cash price because it is the price one would have to pay today "on the spot". But unlike a stock or bond, which is a financial asset, and held as an electronic bookkeeping notation, commodities are physical assets. The purchase of a commodity in the cash market requires the buyer to take delivery of the actual commodity.
As one can imagine, storing barrels of crude oil, bushels of corn, or live hogs, is not easy or without cost and risk. As such, the vast majority of investors in physical assets like crude oil, use exchange futures or OTC forward markets to gain exposure. Here, assets are bought and sold for delivery (which only occurs in a small percentage of contracts) at some agreed time in the future. In other words, an individual can gain exposure to commodities without having to hold the physical asset so long as he or she offsets the original position before the expiration date. Futures/forwards make exposure to commodities much more efficient, but it is not without cost.
There are two specific nuances that anyone employing futures contracts should understand. First, there can be (and often is) a cost to hold a long position in a commodities futures contact in the form of "carry". Second, if the investor wants to hold the commodity longer than the futures expiration, he or she must "roll" the contract to a longer expiration once the contract nears expiration. Detailed explanation of these nuanaces are beyond the scope of this note except to say that by employing an advanced roll methodology, some carry cost may be mitigated or even made an opportunity.
The reason we highlight these is because legacy indices and the ETFs that track them lack an advanced roll methodology and the ability to mitigate carry cost. These ETFs are required to only hold the nearest to expiration futures contract which has historically shown the greatest "cost of carry" expense. While this may not appear meaningful, our research has shown that an advanced roll methodology can contribute as much as an additional 3% of compound average annual return as compared to a front contract only methodology. This is clearly a significant advantage, although it does have potential limitations with regard to liquidity. One advantage to front month only positions is this is where the highest level of open interest and volume resides. This advantage however, would appear to be diminishing as liquidity across contracts is increasing in further dated futures.
To be clear, we are by no means dismissing the merits of ETFs or other products, that employ structures such as focused sector exposure, alternative weightings, active management, liquidity premium, or as a pricing benchmark. These are all important and legitimate tools in an investors toolbox. However, if the primary goal of the investor is to add commodities for diversification, return enhancement and inflation protection, then focusing on a structure specifically designed to meet those goals is prudent. Our research suggests that while traditional legacy indices act as excellent economic benchmarks, ETFs that track these indices are not particularly well structured for inclusion as an investment in a portfolio. In short, when adding commodity exposure via ETF, look for second and third generation funds that are designed to provide the optimal benefits of a commodity exposure.
Shawn Bingham is a 25+ year veteran of the futures and options industry. He was the co-founder of Midwest Trading Partners LLC, a boutique managed futures business catering to HNW clients and fund of funds. Mr. Bingham has recently launched abs(R) Research, a niche firm dedicated to designing next generation alternative asset indices and benchmarks for the investment management community.