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Stocks or futures—which offers the best way to play commodities? The answer, of course, is that "it depends." But in times of contango, says Satch Chada, equities may offer the greater edge.

Chada is a managing director and global head of Investor Solutions for Jefferies Asset Management, LLC, a wholly owned subsidiary of Jefferies Group, Inc. (NYSE: JEF). Jefferies Group now manages more than $3.2 billion in assets worldwide. Last year, JAM teamed up with Alps Advisors Inc. to launch the first family of commodity equities ETFs (NYSE Arca: (NYSEARCA:CRBQ), (CRBI) and (NASDAQ:CRBA) based on the CRB Equity Indexes (CRB-EQ Indices). More recently, JAM again teamed up with ALPS to launch the new Jefferies | TR/J CRB Wildcatters Exploration & Production Equity ETF (NYSE Arca: WCAT). Prior to joining Jefferies, Chada was a managing director at Merrill Lynch, and led development of such products and platforms as the HOLDRS, ELEMENTS and TRAKRS programs

Recently, HAI Associate Editor Lara Crigger spoke with Chada about using equities to play the commodities markets, including the pros and cons of commodities stocks, why so many companies in WCAT are in natural gas and whether the record demand for commodities worldwide can continue.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): What advantage is there in using equities to access the commodities markets, over other means?

Satch Chada, managing director/global head, Investor Solutions, Jefferies Asset Management (Chada): First, they're simple. For example, equity-based ETFs distribute 1099s, which are simpler from a tax perspective than the K-1s distributed by futures-based ETFs. But also, if you take a look at the market capitalization of the equities in the CRB-EQ Composite Index, it's roughly between $4.5 trillion and $5 trillion; it's a gigantic market. If you take a look at the aggregate open interest in corresponding commodity futures, such as oil futures, it's an order of magnitude less. So equities are easy to access for investors; by comparison to their futures counterparts, they're highly liquid and highly tradable.

Crigger: But when you own commodity equities, are you really getting the noncorrelated returns the asset class is known for? Don't commodity equities behave more like equities than commodities?

Chada: Unless you're willing to own spot directly, there's no "pure" way to own commodities.

Crigger: What do you mean by "pure" way to own commodities?

Chada: Let's say that someone wants to own oil. But how do I own oil? Well, I can go buy a barrel of it, put it in my living room, and at some point decide to sell it. But that's not practical. So I go buy a futures contract. If my investment horizon is only a month, or whenever that futures contract matures, that's a fantastic way to own oil, because I know that futures contract and that barrel of oil are going to converge to the same price. But typically, investment horizons are much longer, so investors have to "roll" (sell the front-month contract and buy a back-month contract) those futures contracts forward every time they mature.

But in rolling, you've turned what was a very efficient way to access oil into a very indirect way to access oil. You have to liquidate your current futures contract, go and buy another futures contract that matures further out in time, and so on. And as investors roll their contracts forward, they have incurred significant tracking error and, at least over the past five years, have had to forgo significant performance as compared to the spot price of oil. So there's this assumption that commodity futures are a direct way to get exposure, but in reality, they aren'tnot for the long-term investor in commodities. The direct way is to go buy a gallon of oil or buy spot commodities. For most commodities, investors can't own spot so easily, with the exception of precious metals.

And if you've owned ETFs or other investment products that track commodity futures indices over the last five years, our research indicates that you would have suffered from a 10-plus percent performance drag, relative to the spot price of commodity indices over that five-year period, due to the impact of contango.

Yes, investing in commodities via equities is not perfect, as the day-to-day correlation between commodity equities and spot commodity prices is typically lower than that of spot commodities and commodity futures. But given the competing means of doing it, we believe this is a valid way of accessing the space, particularly over long time periods. This is especially valid since investors are not going to have to deal with the cost of contango, and investors may earn a dividend yield if companies distribute dividends.

Crigger: Are equities equally as appropriate in times when the market is in backwardation?

Chada: That's a good question. If the markets are in backwardation (when front-month contracts are priced higher than back-month contracts), I think that makes it more difficult. Investing is a balance. So in that environment, you may be better off having a higher proportion of your exposure come from futures contracts than equities.

Crigger: How do you think demand for commodities will shift in the coming years? Can places like China or India maintain the pace of demand we're seeing right now?

Chada: There's a persistent demand for commodities, and the factors for those demands aren't slowing down. Certainly the world isn't going to slow down in terms of more peopleI think the latest prediction says there's going to be another billion people in the world in 10 years. China isn't slowing down, India isn't slowing downand we focus on China and India, but really it's all of Asia. You're talking about literally half the world's population moving from a lesser-developed environment to the more-developed world. You're talking about more refrigerators, more cars, more consumptioneven a transition in dietary habits, such as eating more meat (which consumes additional resources).

Currently, the rising commodity prices over the past decade indicate demand is outpacing supply in the commodities markets, and we expect that this will continue, and companies that provide those commodities really have ample opportunities to benefit from that. But at some point, that's going to shift. Supply could outstrip demand.

But that's not going to happen overnight. When the credit crunch happened and put constraints in capital, the projects that were planned that would have increased supply got delayed. Their funding went away. As a result of that, we expect that the commodities cycle that we're currently living in is actually going to be longer in duration than initially expected.

Crigger: How do you mean? How long do you see the current cycle lasting?

Chada: You ran an interview with Jim Rogers not too long ago, right?

Crigger: Yes, we did.

Chada: Jim has said that a typical commodities cycle lasts anywhere from 10-20 years, and I think his expectation is that we started the most recent cycle in 1997. I think the long end of that range is more likely, so I think we're probably right in the middle of the cycle. We probably still have many more years to go.

Crigger: Should investors take an active or a passive approach to their commodities space?

Chada: It depends a lot on the investor. For a typical investor with a portfolio that's not in the ultra high-net-worth segment, I think the passive approach works. You can get 80-90 percent of the gains in terms of portfolio benefits and reduction of risk through a passive ETF strategy.

Now, for the ultra-high-net-worth client, it's probably a mix of passive and active.

Crigger: So tell me a little about the new Wildcatters ETF.

Chada: The idea is: There's a lot of energy ETFs out there, as there's good reason for investors to be allocated to the energy markets, both through futures and equities. But the current equity ETFs out there are mostly focused on the large-cap companies, including some of these exploration and production-based ones. So we decided to offer investors an ETF that allows them to further segment the energy sector.

WCAT tracks the Thomson Reuters/Jefferies CRB Wildcatters Energy E&P Equity Index (WCATI). The WCATI looks at stocks with market caps between $200 million and $2 billion; so, small-cap and smaller midcap companies. And if a company goes above $2.5 billion in market cap, it gets kicked out of the WCATI index.

Crigger: So why does WCAT focus on smaller companies?

Chada: The thing about small-cap products is that they don't have as much media or research coverage. The companies are generally less well known among investors, not like an ExxonMobil or a Chevron. So it's hard for investors to go and pick out one or two small stocks and call it their small-cap exposure.

But the ETF platform is ideally suited for that. You're getting access to over 50 companies in that sector, and these companies are generally focused in on oil and natural gas. They're all domiciled in the U.S. or in Canada. In one quick shot, investors get to trade this whole basket.

Since these companies tend to have higher volatility than some of the larger-cap stocks, frequent or high-velocity traders can express short-term views much more decisively with this ETF. On the other hand, if you own the large-cap energy companies, but you want to complement those holdings with something in the small-cap space, then this can give you portfolio completion within this sector.

Crigger: Why have you focused so heavily on natural gas companies? Currently two-thirds of the companies in your portfolio are involved in the natural gas sector.

Chada: U.S. and Canadian companies have a lot of exposure to natural gas. And there's a trading benefit to it, too. If you look at UNG, which has been an incredibly attractive product over the past year, people can potentially use thisas a substitute or combined in a portfolio with UNGand hopefully get a little more performance. UNG fell quite a bit last year.

Crigger: And yet investors kept plowing more money into it.

Chada: Investors seem to want high exposure to natural gas. So now they have the ability to take a more equity-based approach to a long-term investment and avoid the head winds resulting from the issues related to contango with futures-based products.

Crigger: WCAT's expense ratio is a little higher than some of the other energy equity ETFs out there, like FCG, IEO, XOP and so on. What accounts for the higher expenses for this fund?

Chada: We're at or around the median for other ETFs. If you look at products like UNG, or look at some other commodity ETF products like DBC and other products in the broader commodity space, they tend to be higher.

But if you compare us to products like XLE, we clearly have a higher expense ratio than that. A big reason for that is that we're just starting out, and we don't have very many assets. Also, it's a very specialized niche product, and that's also driving the price. Still, we may revisit that at some point.

Source: Using Equities to Play Commodities