Commodity Index Funds: The Good, The Bad and The Ugly 11 comments
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Because of renewed fears of inflation, there has been considerable interest as of late in Commodity Funds. And for good reason: during that last bull market, commodities experienced a great run-up in prices.
On the Plus Side
- Commodities are an excellent inflation hedge.
- Commodity Index Funds have historically provided superb diversification benefits.
- In recent years, many new commodity ETFs and ETNs have come on the market. These new products have made it easier for the retail investor to obtain exposure to commodities.
- Many academic studies have shown that a diversified basket of commodity futures historically have had equity-like risk and return characteristics, while being negatively correlated with stocks.
Various Commodity Index Funds are available from vendors. To learn more about these indexes, fellow Seeking Alpha author Don Dion write a comprehensive article titled “The Ultimate Commodities ETF Guide” http://seekingalpha.co...
Not All Commodity Indexes Are Created Equal
A large number of academic studies have been published that show the superior performance of commodity indexes. The authors have shown that a diversified basket of commodity futures have provided equity-like risks and returns, while being negatively correlated with stocks. There are three competing commodity indexes. When compared over several decades, the out performance occurred in only one of the indexes, whereas the remaining two commodity indexes had meager performance. The difference in performance is dependent on the criteria used to construct the basket. Could this be due to data mining? Even if the out performance is not due to a data artifact, the investor still has only a one-in-three chance of picking the highest performing index.
The Jig Is Up
While the superior performance of commodities has occurred in the past, it is clear that investors have caught on, and have flooded the market to chase returns. When too many people know about a good thing, it no longer becomes a good thing. In a recent research paper written for the Bank of International Settlements titled “Financial Investors And Commodity Markets” http://www.bis.org/pub... the authors raise the concern that Commodity Markets have grown too big for their pants:
Financial activity in commodity markets is large compared with the size of physical production and has grown much faster in recent years. For gold, copper and aluminium, the volume of exchange-traded derivatives was around 30 times larger than physical production in 2005 – a significant increase in this ratio from 2002.
Yes Commodity Futures have a negative correlation with other asset classes. It appears that the outsized long-term gains of the past will no longer be true in the future. Maybe Commodity Index Funds will still provide excellent diversification benefits, but the long-term returns going forward are sure to be lower. As one financial expert quipped “you can’t eat negative correlations.”
Diversification Benefits Are Decreasing
In the same BIS report, Alexandra Heath and Dietrich Domanski write:
The share of non-commercial net long positions appears to have been less influenced by perceived diversification benefits than in the past. In the earlier subperiod, before prices started to accelerate, there is a negative relationship between investor activity and the correlation between returns on commodities and world equities in most cases. In the second subperiod, this relationship is either statistically insignificant, or has a perverse sign.
Counter-Party Risk
Many Commodity Index Funds are structured as Exchange Traded Notes (ETNs). Unlike ETFs, the much riskier ETNs expose the investor to counterparty risk. During the global financial crisis, Lehman had backed a large number of ETNs. Investors at the time were extremely nervous about their exposure to Lehman and many were forced to sell their positions, at the worst possible time, in order to eliminate the risk of a Lehman default.
Summary
- Studies have shown that due to overwhelming investor interest, commodities are in danger of losing their diversification benefit.
- The investor has a one in three chance of choosing the index with superior returns.
- Commodity Index Funds are expensive to hold, the typical ETF and ETN charges 0.75% in annual expenses.
- Most of these funds use the ETN structure with its inherent counter-party risk.
- Due to enormous investor interest, the outsized long-term gains from commodities is the past, will not be repeated.
- There are less expensive, less risky investment products that provide protection from inflation.
This asset class is suitable for the speculator, but unsatisfactory for the prudent investor. The prudent investor would be wise to avoid this asset class.
Disclosure: Author holds no position in commodity derivatives. You should perform your own due diligence and consult with a professional before investing.
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This article has 11 comments:
Commodities is a fancy word for "stuff" and as such, prices will rise or fall in response to supply and demand for "stuff." The recent sure related to huge new sources of demand as economies in places like India and China started to seriously strut. The bust came in response to corrections there, as well as in some excesses here (i.e. investment demand that ran too far too fast). At this point, we really need to be seeing commodities more as a play on global economic growth. As to the inflation hedge, we;ll need to wait a while, let a full business cycle get underway, and see what happens; whether commodities still have appeal on this ground.
Interestingly, in making your harsh judgment against commodities you missed the main point that could have been raised to support your case; the impact of contango and negative roll yield, and how they imact ETF-ETNs (and ofcourse, you;d have to cover the flip side; backwardation and positive roll yield). That's a very odd omission.
On May 10 11:10 AM Marc Gerstein wrote:
> There are some valid points here, particularly regarding counterparty
> ETN risk and the increase in correlation between commodities and
Thank you for your kudos
> you missed the main point that could have been raised to support
> your case; the impact of contango and negative roll yield, and how
> they imact ETF-ETNs (and ofcourse, you;d have to cover the flip side;
> backwardation and positive roll yield). That's a very odd omission.
>
You are indeed correct: I thought about adding a paragraph about the positive roll returns during backwardation, but I wanted to keep the piece short.
If you could post an elaboration in the comments section, it would be helpful to the readers and help support the case against commodities. Thanks in Advance!
Some articles on Asset Allocation say you should have "5% Commodities." The average retail investor does not understand the positive roll returns during backwardation (and the absence thereof during cotango).
I will add a 7th negative aspect about commodities: "no one should invest in something that they don't fully understand."
Because commodities are futures contracts with expiration dates, no investor can buy and hold. The best they can do is rollover into a new contract as expiration approaches. when contango is present,they'll pay a premium to do this, and that can really cut into the returns one might expect to see based solely on examination of spot price trends. (Backwardation is the reverse, where the futures trade at a discount to fair value and rollover creates a bit of a windfall. But in rising markets, contango is more likely.)
That said, i stilll would not necessarily describe commodity ETFs as speculative (I'm not a fan of the ETN). Whether they are or not is as we see for stocks; it all depends on what's happening in the market. Sometimes, commodities attract huge amounts of hot money investing and reach prices that are, indeed, speculative. Other times, when the hot money goes elsewhere, commodities can look quite conservative. It's just like stocks. Instead of relying on a pat formula, one must look at what's going on.
My personal opinion is that right now, commodities look fairly reasonable. The next significant move in global demand for tangible goods is more likely than not to be upward, supply seems unlikely to keep pace, and the ot money that was all over commodities a few years ago seems to now be sitting in the spectator section. As to contango, look at how an ETF handles the last commodity rally. It'll provide a clue as to how effective their rollover strategy (how close to expiration they go before doing the rollover and how far out they go with the new contracts) has been. Chances are it won;t change since these rollover protocols are locked in via prospectus; ETFs don't have fund managers playing hunches. But that's my opinion. If I'm wrong, it will probably be because I'm too optimistic about economic prospects going forward.
As to blanket statements that one should have 5% in commodities, I reject all statements that suggest X% in such-and-such asset class. In all case, the appropriate % depends on the risk-return inclinations of each investor, and, of course, market conditions.
Commodities aren't magic. It's just another investment and like others, it should be subjected to basic fundamental analysis (and technical for those into that) and favored when the analysis says "yes" and avoided when the analysis uncovers too many red flags. (By the way, I think the importance,nowadays of tangible goods production is why we've seen commodities become much more correlated with stocks.)
the investor gains positive roll returns (makes money) during backwardation
I would assume that the investor does not get positive roll returns during cotango.
My question to Marc Gerstein is: how does that make commodities a bad investment?
It sort of makes sense. Gold, stuck in a vault, doesn't improve itself all that much over the course of a decade. A well-run company, on the other hand, undergoes continuous transformation of a form that can, over time, increase value.
That said, I like Marc Gerstein's position: the right investment at the wrong time is hardly helpful - one must analyze opportunities in the real world as it is now, not as it may be in a decade. I like commodities for hedging inflation - TIPs and most other fixed income tools are adjusted by the CPI (likely to under-adjust). Long-term, however, I see commodities as best used to preserve wealth, not to build it. (Confession: I like gold - the real stuff, not the paper stuff - because when I buy her jewelry, my wife gives me a big kiss.)
Neither has anything to do with whether commodities are good or bad as an investment. These are just facts of life in the commodity world and need to be understood in order to follow what's going on.
For example, I might be bullish notwithstanding contango if I were to expect the spot price to rise enough to make for worthwhile investment performance even after applying a contango-based haircut. Conversely, if I expect prices to plunge, backwardation might not be enough to cause me to get in. Less extreme prospects either way might make roll yield a more prominent aprt of the investment case.
The bottom line here is that there is a lot to commodities and one can never make a pat pronouncement that they must or must not be owned, or even that they're speculative (sometimes they are, sometimes they aren't, and often they are for some commodities but not others). Oversimplification, superficial assessment, etc.... that is what causes investor pain. That's so with stocks. that's so with fixed income. That's so with options. That's so with commodities, etc.
On May 11 02:05 PM Living4Dividends wrote:
> From my very limited knowledge of commodities
> the investor gains positive roll returns (makes money) during backwardation
>
> I would assume that the investor does not get positive roll returns
> during cotango.
>
> My question to Marc Gerstein is: how does that make commodities
> a bad investment?
If the spot price stays flat or about flat, that ETF will start going to a BIG 0. Check out the performance of OIL, UNG, USO.
Investing in these is in itself a full time JOB. A long term investor is better off spending on education, pay off the house, not borrowing money@25% from credit cards. If you are old, buy annuities.
I think investing in the commodity companies is much better, they just might give you a dividend rather than charge the contango fee.
Yes, I have invested in commodity ETFs and made some lost some, but I will STAY the HECK away from commodities.
On May 14 12:31 PM punk_ash wrote:
> We live in a bizzaro world. All pundits are screaming about commodities.
> The financial firms have flooded the markets with commodity ETF and
> ETN. No one will tell you that most markets are in general in contango,
> especially energy due to storage issues. That means a continuous
> bleeding of your portfolio as you are paying someone to store oil
> and gas.
>
> If the spot price stays flat or about flat, that ETF will start going
> to a BIG 0. Check out the performance of OIL, UNG, USO.
>
Agreed. IT takes alot of work at the returns are minimal. I am also a contrarian - if everyone is doing it, then I'll do something else.
>
> I think investing in the commodity companies is much better, they
> just might give you a dividend rather than charge the contango fee.
>
Agreed. It is better to own the companies with the physical commodity already in the ground