As promised in our recent newsletter, “Gold, Worth Its Weight (In Your Portfolio)?,” we’re back with a sequel, this time addressing commodities exposure beyond gold and precious metals. This so-called broad-basket commodities exposure includes industrial metals, as well as crude oil, natural gas, and agricultural grains, to name a few.
As we wrote with regard to gold, we’ve been reluctant to advocate direct purchase of broad-basket commodities, though our clients generally do own commodities indirectly through commodity producers held in broad-based stock index funds.
This reluctance stems from the same challenges we discussed with gold, which we’ll briefly recap below. But it also results from some structural nuances and complexities specific to the types of investment vehicles (namely, exchange-traded products, or ETPs) that are increasingly used for broad-basket commodities exposure. These structures differ from the one typically used for gold/precious metals ETPs (i.e., grantor trust), which we discussed in our last newsletter.
In examining these structures, we’ll highlight two specific ETPs: PowerShares DB Commodity Index Tracking Fund (ticker: DBC) and iPath® Bloomberg Commodity Index Total Return Exchange Traded Note (ETN) (ticker: DJP). Please note that our intent is not to pick on these two ETPs per se; rather, they currently are the two largest broad-basket commodities ETPs in the United States and happen to represent the two particular fund structures we’ll be addressing.
First, let’s revisit some of the broader concerns we have with commodities as investments. Fundamentally, we prefer to invest in assets that generate cash flow and therefore, by definition, are anchored by some underlying basis of intrinsic value. Commodities don’t produce income or have a stake in future profits of a business; they simply are worth what other investors are willing to pay for them, which is ultimately speculative.
Furthermore, the two primary reasons typically set forth for commodities’ inclusion in portfolios have been subject to debate. The first is diversification. Historically, while there have been periods when commodities moved out of lockstep with stocks (or, in more technical terms, exhibited non-correlation), this has not consistently been the case. Indeed, commodities were down substantially—and thus were quite correlated to stocks—during the recent financial crisis. As you can see in the table below, in 2008, bonds, in aggregate, proved to be the asset class that was least correlated to stocks, thus providing a valuable diversification buffer during this period.
Interestingly, commodities’ correlation to stocks (U.S. stocks in particular) began to increase dramatically around 2007, right before the onset of the financial crisis. This coincided with a rise in commodities fund assets, which has led to a theory referred to as the financialization hypothesis. The hypothesis claims that the rise of financial players in commodities markets, beyond traditional commodities purchasers and producers wishing to protect (e.g., hedge) themselves, moved the prices of materials such as oil and grains away from the fundamentals of supply and demand. For investors who had piled into commodities funds for diversification purposes, these price distortions may have led to the lack of a diversification benefit when they needed it most!
The second reason typically proffered for commodities’ inclusion in portfolios is that they provide dependable inflation protection. This makes intuitive sense, given that inflation is defined, more or less, by commodity prices. But even this popular notion has been contested. In a recent academic paper published in the Journal of Wealth Management,1 the authors examined the return performance of 45 spot commodities and 13 commodity aggregates over a 53-year period (1960 to 2012) and found that their ability to act as reliable inflation hedges was weak. Indeed, energy, in aggregate, was the only commodity that provided an inflation hedge consistently over all high-inflationary periods throughout the 53-year period study. Still, the authors caution that energy, like commodities in general, can be quite volatile, and they also note that the sector is undergoing rapid technological transformation, which could change its hedging characteristics in the future. Finally, the authors point out that if commodities are to be used as an inflation hedge, the timing of their purchase is crucial—and determining the optimal timing, they acknowledge, is exceedingly difficult for most investors.2
Know What You Own: Example 1
Before buying a broad-based commodities investment vehicle, investors should clearly understand the structure of the vehicle itself, and specifically its underlying holdings. This is because most broad-based commodities investment vehicles do not invest in commodities directly (though some precious metals funds/ETFs do). Rather, most broad-based commodities investment vehicles, such as DBC, buy derivatives—primarily futures contracts—to replicate the exposure of the commodities themselves.
The reason for this is that unlike a gold fund that can own and store gold bars in a bank vault, broader-based commodities funds can’t easily own the materials they invest in, such as perishable agricultural commodities or industrial commodities, which require much greater storage capacity that would be prohibitively costly. Instead, broad-based commodities vehicles such as DBC typically buy futures contracts (the promise to get a delivery of a commodity at a certain date and price in the future) and roll their assets over to another contract whenever the current one is about to expire. If a fund is holding a contract when it expires, it would be obliged to take delivery of the underlying commodity itself, which again would most likely be unfeasible (just imagine a fund being forced to take delivery of millions, if not billions, of dollars’ worth of oil!).
Due to the nuances and inefficiencies of using futures contracts, replicating exposure via derivatives does not ensure that a fund will be able to closely track commodity prices in the here and now (referred to as the spot price). Indeed, there have been instances in which investors have seen the price of their commodities funds go down even though the price of the underlying commodity went up. Moreover, as commodities funds have proliferated, their need to buy and sell large amounts of futures contracts sometimes puts them into the position of influencing futures prices, rather than simply tracking them.
A significant component of the returns of futures-based commodities funds comes from what is referred to as the roll yield. As mentioned earlier, funds roll over their futures contracts, typically from month to month. That is, they are continually selling contracts as they near expiration and buying new ones. While commodities funds generally make money when commodity prices are rising (i.e., when there is a positive roll yield), in certain situations this is not the case, such as when futures prices are higher than the current spot price for a commodity. This phenomenon is known as contango. In a contango environment, a fund is forced to sell expiring contracts at a lower price and reinvest the proceeds into higher-priced contracts (for a negative roll yield).
Going back to our specific example, DBC seeks to minimize the effects of negative roll yield through a rules-based tactical strategy in which it occasionally rolls over short-term futures contracts into longer-term contracts, instead of following a more traditional front-month contract selection process. However, this may result in investors missing out on short-term upward moves in spot prices, as longer-dated contacts tend to be less sensitive to spot prices. (Of course, this also means investors may appreciate the downside protection when spot prices fall.)
Finally, it bears mentioning that investors in commodity futures must set aside collateral. Therefore, as is typical with futures-based commodities investment vehicles, DBC collateralizes its futures positions, primarily with U.S. Treasuries. As a result, another component of the fund’s return is the interest income generated from this collateral (which is referred to as the collateral yield).
Know What You Own: Example 2
The current second-largest broad-based commodities exchange-traded product, DJP, represents an entirely different structure from the futures-backed DBC, in that it is an exchange-traded note (ETN). As the term note implies, ETNs are unsecured bonds issued by a bank (Barclays, in the case of DJP) that agrees to deliver the return of the index it tracks. In other words, the amount of interest that is paid to the ETN investor (lender) during the term of the note is the return of the underlying commodities index it tracks, net of fees.
One benefit often touted for ETNs is that they closely follow their underlying indexes (no tracking error), while futures-backed vehicles such as DBC may not always follow their indexes (tracking error). The ETN provider commits to paying the index return, less fees, whereas futures-based funds may diverge from the indexes they track due to the structural issues/constraints we discussed earlier (i.e., negative roll yield/contango).
In reality, however, the lack of tracking error is not necessarily assured in all cases. Some ETNs, such as DJP, carry embedded fees that are dependent on the sequence of the underlying index returns (so-called path-dependent fees). As a result, even if the underlying index had the same annualized compounded return under two scenarios, the investor could end up netting a significantly different return under each scenario, depending on the specific sequence/path of the year-to-year returns for each scenario.3
ETNs also claim tax advantages, particularly relative to futures-based ETFs such as DBC. The latter are typically structured as limited partnerships (LPs) and have unique tax considerations. LP ETFs are considered pass-through investments, so any gains made by the fund could create a taxable event for investors. These investors also receive K-1 forms. As a result, it typically makes sense for investors to hold vehicles such as DBC in a tax-sheltered portfolio such as an IRA.
ETNs, on the other hand, are often touted as being more tax-efficient. They are defined as prepaid contracts, and investors pay tax only on capital gains received at the time of sale. But that could change, because as of this writing there has not been a final IRS ruling on the taxation of ETNs. Indeed, as stated in DJP’s prospectus, “The U.S. federal income tax consequences of your investment in the ETNs are uncertain and alternative characterizations are possible.”4
The biggest drawback of ETNs, however, is their credit risk. Again, ETNs are unsecured debt obligations of an issuing bank; therefore, investors can lose all or the bulk of their investment if the issuer goes bankrupt. Most ETN issuers are large financial institutions with investment-grade credit ratings. However, with the financial crisis in 2008 and 2009 serving as a stark reminder, credit risk should not be discounted. In fact, Lehman Brothers had three ETNs outstanding at the time of its bankruptcy in September 2008, and investors who owned shares of these ETNs at the time lost a substantial part, if not all, of their investments.
As you can see, investing in commodities is not only speculative but can be a rather complex endeavor. While the advent of ETPs has made commodities exposure more accessible, it behooves investors to understand their specific structures and, in turn, potential risks and drawbacks. Furthermore, while these ETPs may provide relatively low-cost access to an asset class that is otherwise difficult to invest in, they are typically more expensive than traditional broad-based stock and bond index funds.
Of course, our ultimate task continues to be to create and follow a plan that offers our clients the highest chance of financial success. When it comes to investing, we’ve long held that success is not predicated on complexity—even though many in the industry and the financial media often promulgate otherwise, arguably for their own self-interest. Indeed, one of our heroes, John Bogle, the founder of Vanguard and often a critic of Wall Street, once wrote, “The key to whatever success I may have enjoyed during my long investment career is that the Lord gave me enough common sense to recognize the majesty of simplicity” (emphasis ours).5
We remain unconvinced that investors need the added complexity and cost of dedicated commodities exposure to achieve their financial goals. Even those who do advocate commodities exposure typically advise allocating only a small percentage of one’s portfolio to them, given commodities’ inherent speculative risk and volatility. And in light of energy and materials companies currently representing roughly 12% of the world’s aggregate stock market value, we believe our clients remain amply served by attaining their commodities exposure indirectly, through less-complex, lower-cost, more tax-efficient broad-based stock index funds.
With that, we leave you with a KISS: “Keep It Simple Sweetheart!”
1. George Crawford, Jim Kyung-Soo Liew, and Andrew Marks, “Spot Commodities as Inflation Protection,” Journal of Wealth Management, Volume 16, Number 3 (Winter 2013): 87–111.
2. “Commodities an Unreliable Hedge Against Inflation,” Changing Business, Johns Hopkins Carey Business School, Fall 2014.
3. For a hypothetical example of this, we refer you to pages PS-10 and PS-11 in DJP’s current prospectus.
4. Per page PS-20 in DJP’s prospectus.
5. John Bogle, Don’t Count on It!: Reflections on Investment Illusions, Capitalism, “Mutual” Funds, Indexing, Entrepreneurship, Idealism, and Heroes (New York: Wiley, 2010), p. 49.