Last week I wrote about the risk and rewards associated with agricultural commodities. Several readers have asked me to expand the analysis to other commodities so this article analyzes broad-based commodity funds.
Commodities are "real assets" that run the gamut from oil and precious metals to agriculture. Whether or not this volatile asset class deserves a place in a conservative portfolio is a matter of debate but many financial planners recommend from 3% to 10%, depending on your investment objectives, time horizons, and risk profile. There are two main reasons typically given for these recommendations. The first is that commodities provide a hedge against inflation since commodity prices tend to increase as the cost of living marches higher. The second reason is diversification. Commodities tend to have a low correlation with traditional asset such as stocks and bonds.
If you decide to give commodities a try, trading futures is the purest way to gain exposure. However, for most investors, buying Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs) is the most convenient way to invest. The main question then is: what are the "best" funds to purchase?
There are many ways to define "best". Some investors may use total return as a metric but as a retiree, risk in as important to me as return. Therefore, I define "best" as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.
This article will analyze a few of the broad-based commodity Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) to assess relative risk-adjusted performance over the past few years. ETNs will be discussed in more detail later but are a cousin to ETFs and serve basically the same purpose for traders.
Rather than storing commodities, most ETFs are based on future contracts. Futures are contracts that allow you to buy a product at a fixed date in the future for an agreed upon price. Future contracts expire and if you want to maintain a position, you have to repurchase another future contract. Depending on market conditions, the longer dated future contract may sell at a higher price than the current contract so when the current contract nears expiration, it has to be rolled over to a more expensive contract. When this happens, you lose money even though the price of the underlying commodity has not changed! This characteristic of rolling over to higher priced contracts is called "contango". Similarly, if the longer dated contract sells at lower price than the current contract, you will make money when you roll over the contract. This condition is called "backwardation". Historically, commodities are in contango about 70% of the time. The rolling methodology, called roll yield, is an important driver of overall fund performance.
Commodity ETFs invest in a portfolio of these future contracts. However, some fund companies decided not to actually hold the contracts but instead promise to provide the same return you would receive from owning the futures. These agreements are called ETNs. Since the company issuing the ETN is obligated to pay the holder the same return (less fees) as would be obtained by investing in the underlying futures, ETNs track the index exactly (ETFs may have tracking errors). ETNs also have the advantage of more favorable tax treatment than future-based ETFs. However, on the negative side, ETNs have "credit risk" to account for the fact that ETNs might not be redeemed if the issuing company becomes bankrupt.
The number of commodity ETFs/ETNs has expanded over the past few years and it is now possible to invest in a wide range of both individual and baskets of commodities. Unfortunately, many of these funds are small and illiquid and are not suitable for most investors. The ETFs/ETNs analyzed in this article are broad-based funds and were selected based on the following criteria:
- The fund must have adequate liquidity and trade an average of at least 30,000 shares per day.
- The fund must have a market cap of $100 million or more.
- The fund must invest exclusively in commodities.
- The fund must have been launched before May, 2011 (have at least 3 years of history).
The funds that satisfied these criteria are summarized below.
PowerShares DB Commodity Index (NYSEARCA:DBC). This ETF tracks an index of 14 commodities from four sectors. Energy makes up 55% of the portfolio and includes oil, gasoline, and heating oil futures. The second highest allocation is agriculture at 22% and includes sugar, corn, wheat, and soybean futures. Industrial metals consume 13% of the portfolio and includes copper, zinc, and aluminum. Precious metals weight in at 10% and includes gold and silver futures. The fund utilizes a roll strategy that tries to optimize the roll yield. The fund has an expense ratio of 0.85% and does not provide any yield.
iPath DJ UBS Commodity Index (NYSEARCA:DJP). This is an ETN that promises to pay holders the same return as a broad-based index of 20 commodities. Agriculture (grains) and energy each make up about a third of the portfolio. The remaining third is split among industrial metals, precious metals, and livestock. This ETN employs a roll strategy based on the rolling the front month, which makes it susceptible to contango. The ETN has an expense ratio of 0.75% and does not provide any yield.
iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG). This ETF is heavily weighted (70%) toward energy (oil, natural gas, and gasoline). The rest of the portfolio is split among agriculture (15%). industrial metals (7%), livestock (5%) and precious metals (3%). The fund employs a roll strategy based on rolling the front month, which makes it susceptible to contango. The fund has an expense ratio of 0.75% and does not provide any yield.
UBS E-TRACS CMCI Total Return (NYSEARCA:UCI). This ETN tracks a basket of 26 commodity futures over different maturity dates from 3 months to 3 years. The portfolio is comprised of 34% energy, 27% industrial metals, 5% precious metals, 30% agriculture, and 4% livestock. UCI is not very liquid so you should use only limit orders if you decide to buy or sell this fund. The fund has an expense ratio of 0.65% and does not provide any yield.
ELEMENTS Rodgers International Commodity (NYSEARCA:RJI). This ETN tracks an index of 37 commodity future contract, making it one of the most diversified baskets of commodities. It is rebalanced monthly based on worldwide consumption. Typically, energy makes up about 44% of the index, metals weigh in at 21%, and agriculture is 32%. The fund's return is based on rolling over future contracts each month so it may experience contango, depending on market conditions. The fund has an expense ratio of 0.75% and does not provide any yield.
GreenHaven Continuous Commodity Index (NYSEARCA:GCC). This ETF tracks 17 equally weighted commodity futures. The equal weighting translates to more emphasis on agricultural products (46%) and less focus on energy (18%) than its peers. Other holding include 24% allocated to metals and 12% to livestock. To mitigate contango, this fund purchases a set of future contracts that covers a six month period rather than just the front month. The fund has an expense ratio of 0.85% and does not provide any yield.
United States Commodity Index (NYSEARCA:USCI). This ETF tracks an index that uses a rule based methodology to select 14 commodities out of a pool of 27. The selection is based on contango and momentum and the selected futures are weighted equally for the month. The portfolio changes each month but over a long period, energy has averaged about 25% of the portfolio with grains coming in second at 22%. The fund was launched in 2010 so does not have a long history. It has an expense ratio of 0.95% and does not provide any yield.
In addition to ETFs and ETNs, I also included the mutual fund described below.
PIMCO Commodity Real Return Strategy A (MUTF:PCRAX). This mutual fund tracks the Dow Jones-UBS Commodity Index by using a combination of derivative that requires only a small amount of cash as collateral. The managers attempt to beat the index by investing the excess cash in bonds, primarily U.S. Treasury Inflation Protected securities. This strategy could boost returns but can also court losses if interest rates spike. The fund has an expense ratio of 1.2% and yields 2.4%.
I first looked at funds that had a 5 year history and used the Smartfolio 3 program (www.smartfolio.com) to plot the rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus historical volatility. I also added the SPDR S&P 500 (NYSEARCA:SPY) ETF to compare performance of the funds with the S&P 500. The results are shown in Figure 1.
Figure 1: Risk versus reward past 5 years.
The figure indicates that there has been a wide range of returns and volatilities associated with these agriculture funds. For example, UCI had a high volatility but also had a larger return than most of the other funds. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each fund.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of DBC, which is the most popular commodity ETF. If an asset is above the line, it has a higher Sharpe Ratio than DBC, which means it has a higher risk-adjusted return than DBC. Conversely, if an asset is below the line, the reward-to-risk is worse than DBC.
Some interesting observations are apparent from the plot. Over the past 5 years, all the commodity funds substantially underperformed the S&P 500 index. The commodity funds also exhibit volatilities in the same ballpark as SPY. Within the commodity asset class, the PICMO mutual fund booked the largest return with about the same volatility as DBC and SPY. Thus, PCRAX had the best risk-adjusted return among commodity funds. If we limit the analysis to ETFs, UCI had the best performance, suggesting that the strategy of diversifying across both commodities and maturities worked well. RJI booked the second best performance among the ETFs providing a validation of the index formed by Jim Rogers in the late 1990s. The most popular commodity ETF was in the middle of the pack in terms of performance. DJP lagged and turned in the worst risk-adjusted performance over the period.
One of the often cited reasons for investing in commodities is the diversification they offer equity portfolios. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The results are provided in the 5 year correlation matrix shown in Figure 2 and indicate that commodity ETFs are only moderately (50% to 60%) correlated with the S&P 500. Thus, commodities did provide a reasonable amount of diversification. It should be noted that all the funds are highly correlated with one another, with UCI being the least correlated among the group.
Figure 2. Correlation matrix over past 5 years
Next I wanted to assess if the performance changed if we reduced the look-back period to more recent times. I re-ran the analysis over the past 3 years from May, 2011 to May, 2014. During 2013, commodities were an unloved sector, with the first half of the year devastating these funds. Grains and coffee in particular had bad years. The overall risks and rewards during this period are depicted in Figure 3. It is not a pretty picture with all the commodities funds being underwater. The Sharpe Ratio is not useful when looking at negative returns but a few conclusions can still be gleamed from the plot. The new kid on the block, USCI, did relatively well. UCI, RJI, and DBC were able to minimize losses. GSG had the smallest loss but also had the highest volatility.
Figure 3: Risk versus reward past 3 years
If we narrow our view to the past year (May 2013 to the present), then the performances have improved, with most funds pulling themselves back into positive territory. The results are shown in Figure 4. USCI has now moved substantially ahead of the pack, suggesting that their rule based selection methodology is adding value. GCC and RJI were the best performers after USCI. Interestingly, both DBC and PCRAX have continued to have problems.
Figure 4: Risk versus reward past 12 months
Commodity funds do provide reasonable diversification so are worthy of consideration but this has not been a rewarding asset class, especially over the past 3 years. If inflation picks up, the performance of commodities should improve. However, since inflation has been dormant over the past five years, my analysis was not able to confirm or deny the inflation protection afforded by this asset class. If you are a risk tolerant investor and would like to delve into commodities, I would recommend taking a look at USCI and RJI as candidates for your portfolio. UCI is another candidate because of its smaller correlation with other funds but it has faltered a bit over the past 12 months.
Disclosure: I am long RJI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.