To limit or not to limit? That is the question on Washington's mind right now, as regulators struggle with how best to cope with the volatility of commodities funds like UNG. Given the regulatory frenzy over energy ETFs, we thought it might be a good time to check back in with Richard "Rick" Ferri, founder and CEO of Michigan-based Portfolio Solutions, LLC.
Mr. Ferri, who spoke with the voice of caution during our Great Commodities Debate, is an adjunct professor of finance at Walsh College. He has written five investment books; the second edition of his latest, "The ETF Book," was released earlier this month. Before starting his own firm, Mr. Ferri worked as a stockbroker with two major Wall Street firms for 10 years.
HAI Associate Editor Lara Crigger spoke with Mr. Ferri earlier this week about commodities and ETFs, including whether position limits could be helpful, the creeping cost of new funds and why his feelings about commodities haven't changed.
Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Last time we spoke, you said you didn't include commodities in your clients' portfolios, because their returns just didn't justify it. Do you still feel this way?
Rick Ferri, CEO, Portfolio Solutions (Ferri): Yes. If the reason people buy commodities is because they think they're going to protect themselves in a down market, they have to come up with a different reason. In the last year or so, I think many people learned that commodities are not negatively correlated with stocks. There are times when they are negatively correlated, of course, but to believe that commodities are some sort of panacea for a bad stock market was always incorrect thinking. The past 14 months finally proved that.
Crigger: That's a short-term phenomenon. Shouldn't we look over the longer-term picture before saying that?
Ferri: Yes, it is a short-term phenomenon, and it only occurs when there is a financial crisis—right when you need it to not happen the most. It happened after the tech wreck in 2000; the worst periods for stocks were some time in the fall of 2002, exactly the same time when commodities started sinking.
When you have a real downturn in the global economy, there's less demand for commodities, of course, and so you'd expect commodity prices to fall. So if you're an astute observer, you look at the worst time for stocks and see that's when the correlation between stocks and commodities picks up.
When you had me on Hard Assets for the Great Commodities Debate, the message I tried to get across is: Commodities as a cure for a downturn in the stock market is not the answer. If you're going to use commodities the rest of the time, the other 80%, then yeah, there's a low correlation between the two, and at times even a negative correlation.
But that's not the whole story, though. The rest of it is: Will commodities actually deliver real returns after inflation? The answer to that is no. You'll get a lower volatility some of the time with commodities, but you'll also get a lower return. And that's what I think many people miss.
I don't think anyone now disagrees that commodities are expected to have a 0% long-term return after adjusting for inflation. I don't think anybody argues with that anymore. So what's the benefit then of taking stocks out of your portfolio that have a real positive return after inflation, and putting that into commodities? I don't get it.
But I'm not anti-commodities. I don't think they belong in a long-term asset allocation strategy, no. But they are trading vehicles. If you were going to speculate with your fun money, then yeah, sure, go ahead and include commodity trading like collateralized commodities futures or ETFs.
Crigger: What about commodities ETFs? Do you feel the same way about them?
Ferri: There's a big difference between the structure of commodity products like GLD—which is actual, physical gold that you own—and something based on the GSCI index or a Jim Rogers index. Those are all futures products; they're all strategies on futures products. So you have to be careful that you're differentiating between what's a commodity and what's a futures contract. I think what you're beginning to see are problems developing with the futures-based products that nobody had anticipated.
Crigger: Certainly the best example of that is UNG, right? That fund's gone haywire lately.
Ferri: John Bogle once said that, "When it comes to the fund industry, nothing fails like success." That's a good observation when it comes to this natural gas ETF and others like it. They became so popular that they outstripped the ability of the supply of futures contracts available. Nobody anticipated that, but that's how these things work. It's like exchange-traded notes: Nobody ever anticipated Lehman Brothers going bankrupt, so nobody ever gave much consideration to the fact that ETNs are an unsecured obligation of the issuer, until Lehman went bankrupt. So these unintended consequences do pop up after the fact. They are very new, and we're all learning about the problems that some of these structures have.
Crigger: Do you think the position limits that the CFTC have proposed could help the situation?
Ferri: I'm not an expert on the legalities of position limits on futures contracts, but I think some of it might be political. There's a lot of finger-pointing going on, and the finger is pointed at ETFs as a reason for the volatility. Whether it's a fact or not is really irrelevant. Politically, it certainly sounds good. So the regulators are having a bit of a knee jerk reaction to what's happening in Washington. At least for right now, it's an issue.
Will it be resolved later down the road? As the true facts come in, will we see that ETFs aren't creating more speculation in the commodities markets and the futures markets? Maybe. But right now, Wall Street is not the favorite son of Washington, D.C. So you probably are not going to see that for awhile.
Did the ETF buying up futures contracts actually cause prices to move in the natural gas markets or not? Really that question has not been answered. So these restrictions are political reactions: "What seems to be the culprit? Let's go after this."
Crigger: It makes it look like they're actually doing something useful or proactive.
Ferri: The issue is if it's really useful or detrimental to the free-market economy. Is it actually creating more volatility, or creating more problems than they think they're solving? Again, I am not an expert in this, so I couldn't tell you that. But I don't think anybody has the real true data on this. We're just making decisions without regard to good academic analysis about whether or not this is what's causing volatility in commodities prices.
Crigger: Have commodities ETFs helped to increase the average costs of ETFs overall?
Ferri: There are a lot of ETFs being issued right now that are more expensive, because all the easy stuff is done. All the traditional benchmark-type index stuff is done now. So what you've got now are ETFs being launched based on trading strategies. In "The ETF Book," I break this all down, but you've got benchmark indexes and you've got strategy indexes. The strategy indexes are nothing more than active management strategies that have been computerized into something they call an index. The selection and weighting rules for the index have been commoditized. So ETFs based on those strategy indexes are more expensive; it doesn't make any difference if it's a stock ETF or a bond ETF or commodities ETF.
That said, for some reason, when you look at the new equity and fixed-income ETFs coming out based on these strategies, commodities ETFs are still even more expensive. The reason is supply and demand. Right now, consumers are willing to pay more for them, because commodities are a hot market. Just like every other mutual fund provider out there that, back in 1999-2000, put out a technology mutual fund, now they're all coming out with their commodities ETFs. How long will it last? Who knows?
