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The ETF industry has gained the momentum of a runaway freight train in recent years, raking in billions of dollars every month as more and more investors embrace the benefits of the exchange-traded structure. Over the last 20 months or so, the commodity ETF space has been the engine of that train, accounting for a significant portion of new industry assets. In 2009, commodity ETFs took in more than $30 billion as dozens of new funds popped up and grew rapidly. That pace has slowed considerably in 2010, but commodity ETFs are still a major driver of the surge in ETF assets (through July, cash inflows stood at about $6 billion).

The tremendous interest in exchange-traded commodity products is relatively easy to explain. Prior to the launch of these products, many investors did not have a cheap, efficient means of tapping into the asset class. There are of course the obvious barriers to establishing exposure to a bar of gold or silver. And commodities exposure through futures contracts is a complicated proposition that requires both tremendous skill and a fair amount of time to monitor and roll holdings. Then commodity ETPs came along, effectively making commodity exposure as simple as buying a stock. Through one ticker, investors have the ability to tap into resources from aluminum to sugar, or even a diversified basket of a dozen plus commodities.

But commodity ETFs haven’t enjoyed such tremendous success just because they’re new toys for investors. There have been plenty of ETFs offering exposure to new asset classes or regions of the world that have fallen flat. In the increasingly competitive world of ETFs, being new certainly does not guarantee being successful.

Commodities have been embraced in the ETF structure because the asset class is perceived to offer very real benefits when included in a traditional stock-and-bond portfolio. That was the thesis put forth in a 2005 paper authored by Yale professors K. Geert Rouwenhorst and Gary Gorton; their research showed that a portfolio of commodity futures delivered returns similar to equities but with negative correlations to stock and bond markets. “For institutional and retail investors alike, this was manna from heaven: equity like returns that are noncorrelated to other markets,” wrote Matt Hougan in describing the study. The exchange-traded structure gave investors access to an asset class they had been salivating over for some time. ETFs were the oil well, suddenly blasting the buried treasure to the surface in massive quantities.

Changing Relationships

There have been a number of interesting consequences from the recent recession. The “risk gap” between developed and emerging markets that were once accepted as certainty has been called into question, as the developing economies of the world have been established as the new leaders. Days of free-spending governments and lavish social benefits are long gone, and risk-free returns are a thing of the past as well.

Another casualty of recent years has been the inverse relationship between commodities and equities. To date in the post-Lehman world, these asset classes have moved in lock step, forcing investors to reassess the potential benefits that commodity ETFs can add within a portfolio. The correlation between the largest exchange-traded commodity product, the PowerShares DB Commodity Fund (NYSEARCA:DBC), and the S&P 500 SPDR (NYSEARCA:SPY) serves as compelling evidence of this trend. From the inception of DBC in early 2006 through August 2008, the correlation between these funds was slightly negative. But since then the correlation has come in around 0.60, with an even stronger relationship (about 0.77) so far in 2010.

Intuitively, the strengthening relationship makes sense. During the recovery, demand for raw materials has fluctuated along with the health of the overall global economy. Reports of strong industrial activity in China boosted the outlook for global equity markets, but also stood as indications of increased demand for industrial metals and energy resources. Conversely, when equity markets hit a rough patch, commodity prices have pulled back along with stocks, as investors expect that slowing manufacturing activity will translate into weaker demand for natural resources. In the eyes of many investors, there is a clear relationship between the strength of equity markets and commodity demand (read: prices).

The diversification benefits offered by commodity ETFs have clearly been diminished in recent months, but that doesn’t necessarily mean that it’s time to write off the asset class. We’re still operating outside the realm of normal market activity; investors have seemingly grouped all risky assets together, making little distinction between Polish stocks and copper futures.

Once global equity markets return to more stable footing, the correlation between stocks and commodities will likely retreat towards zero, perhaps even dipping into negative territory. But for the time being, temper your expectations when investing in commodity ETFs. The diversification benefits of this asset class aren’t dead, but they’ve been knocked down a few levels.

Disclosure: No positions at time of writing.

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Source: Rethinking Commodity ETFs