Alpha-Seeking Investors Should Consider Single Commodity ETFs Too

by: Gary Gordon

More often than not, I appreciate the data and info compiled by the folks at Morningstar. With that said, there are times when I need to call their team to the carpet. When might I feel that desire? Whenever the world-renowned publisher serves up generalized advice that is too simplistic.

Would you care to wager a guess on how Morningstar suggests that you should invest in commodities? You should pursue a Total Commodity ETF with a diversified basket of commodities so that you limit your exposure to the volatility of any single commodity.

Now, if you are a buy-n-holder who has no intention of actively reducing risk, sure… I agree with that approach. GreenHaven Continuous Commodity (NYSEARCA:GCC) was part of my Lazy ETF Portfolio that trounced the S&P 500 in 2010 — 15%+ to 8%.

However, if you are the type of investor who pays attention to financial info for the purpose of decision-making (e.g., economic cycles, China, the U.S. dollar, relative strength, etc.), you should look for non-correlating assets to fill out your portfolio. In fact, true diversification requires holding assets that do not relate strongly to your other holdings.

With a sweeping stroke, however, Morningstar recommends owning a total commodity exchange-traded vehicle like Rogers International Commodity Index (NYSEARCA:RJI), Greenhaven Continuous Commodity (GCC) or iPath DJ Total Commodity Index (NYSEARCA:DJP). Apparently, it does not matter that each one of these assets has an extraordinarily high negative correlation with the U.S. dollar at roughly -.80. (Correlation coefficients travel between -1.0 and 1.0.)

Dollar up, diversified commodity ETF down… dollar down, diversified commodity ETF up. Why is this a problem? When foreign bonds, foreign stocks, U.S. stocks, foreign currencies… when most assets that you already hold are stuck in the same dollar up/dollar down conundrum… you shouldn’t compound your dependency on the currency.

Granted, market-based securities will eventually break free from the U.S. dollar’s movement. Until that time, however, the active investor needs to be far more discerning. For example, iShares MSCI Malaysia (NYSEARCA:EWM) and iShares MSCI Chile (NYSEARCA:ECH) were two of my largest client positions in 2010. One reason? Both represented some of the lowest correlations with the USD$. In contrast, total emerging market funds like iShares MSCI Emerging Markets (NYSEARCA:EEM) are exceptionally dependent on the dollar with a -.75 correlation coefficient.

Morningstar has taken a similar approach with equities as they have with commodities; that is, the generalized advice has often been to own Vanguard Emerging Markets (NYSEARCA:VWO) or iShares Emerging Markets (EEM), not single country emergers. And once again, when it comes to buy-n-hold… okay.

However, if you are like me, you do not subscribe to buying-hoping-n-holding. Therefore, you can’t afford to ignore the lower standardized risk of Malaysia or Chile. You can’t fall into a trap of assuming that a broader-based index is automatically less volatile because it may cover more countries or commodities. And you certainly can’t afford to ignore how different assets correlate with market drivers like the almighty buck.

Just last week, I wrote a feature on several Single Commodity ETFs/ETNs that were not being held hostage by the U.S. dollar’s directionality. Coffee (NYSEARCA:JO), Nickel (NYSEARCA:JJN) and Gold (NYSEARCA:GLD) happened to be some of the examples with negligible correlations to the greenback.

Remember, Total Commodity ETFs have all been moving in the opposite direction of the U.S. dollar. So when the dollar has risen, almost all of your stocks, bonds, currencies, foreign holdings, as well as your Total Commodity ETF have dropped in value. On the other hand, several single commodity ETFs/ETNs have been moving independently… and that’s at the heart of risk-reducing diversification.

Keep in mind, if one or more of your holdings is “too volatile,” the active investor can always use stop-loss limit orders for greater protection. Nevertheless, here’s how several low-correlating/non-correlating commodities have performed in 2010 versus the Total Commodity ETFs.

“Select” Single Commodity ETFs and Total Commodity ETFs
Approx % 1 year
iPath DJ Nickel ETN (JJN) 35.1%
iPath DJ Coffee ETN (JO) 33.0%
SPDR Gold (GLD) 17.0%
Greenhaven Continuous Commodity (GCC) 13.6%
iPath DJ Total Commodity (DJP) 7.5%
Rogers International Commodity (RJI) 6.5%
Click to enlarge

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.