Recently we spoke with Sal Gilbertie, president of Teucrium, to discuss the market for commodity ETPs and how these investments could make for an interesting component of a portfolio. Additionally, we dived into the company’s flagship product, the CORN fund, to find out why investors should take a closer look at this important commodity. We also looked at Teucrium’s methodologies for limiting the impact of contango and why this may be the preferred way to go for a variety of commodity products.
ETF Database (ETFdb): Interest in commodities has surged in recent years. How should investors be using commodities in their portfolio? Or perhaps more importantly, how shouldn’t they be using them?
Sal Gilbertie (SG): The reason we formed Teucrium is because we believe that in the next five to 10 years, all investors will want to have commodities in their portfolios. We believe that the commodity situation around the globe is such that, the middle class is expanding, the population is expanding, and we only have a finite number of resources. With those two forces in effect - the finite supply and almost infinite potential for growth in demand - people are going to be looking at commodities as an asset class in their portfolios.
That is also going to drive down to the retail investor. We think that for the past five or 10 years, commodities have been on the radar screen of most institutional investors, and now in the past couple of years we have seen Registered Investment Advisors and stock brokers get into them. We believe that the next five to 10 years will bring commodities into the mainstream and that everybody will be using commodities in some fashion.
You should use commodities within a portfolio just like any other investment. It should be part of a comprehensive investment strategy that not only mitigates risk, but allows for some appreciation in value. That is where our products fit in. There are several very good commodity indexes out there, and we believe that commodities have a place in every portfolio. A lot of people will go for just a broad based commodity basket.
But that approach really spreads around the risk, and the beta part of your portfolio. If the stock market goes one direction, you are hoping that your portfolio goes the other. That is generally how people have been using commodities. That is fine from a risk management perspective, but from an absolute return/alpha perspective, investors may want to express a position specific to a commodity, promoting growth in the portfolio if they get the call right.
That is where Teucrium’s products come in. We focus on the single commodity sector, primarily energy and agriculture for now. Those are the two commodity groups that people will use regardless of economic situations, be it personal or global. One cannot stop using energy, and one cannot stop consuming food. Those are the two most critical commodities in a portfolio on a day-to-day basis.
ETFdb: More specifically, exchange traded commodity products have seen huge cash inflows over the last several years. So what is it about the marriage of this asset class - commodities - and the exchange-traded structure that is so appealing to investors?
SG: For one thing, the exchange-traded structure allows investors to participate directly in a commodity class rather than having a futures account, and I think that is an enormous issue. If people have an opinion about a specific commodity, they cannot gain exposure because futures accounts are too complicated and leveraged for most average investors. Most people do not have futures accounts, nor should they. It requires a different level of expertise and can be quite risky. Teucrium’s products are unleveraged and completely transparent for that reason. Futures-based ETFs package up futures so the investor knows what they are getting and how to trade them, that is what has made them very popular. For commodity ETFs in general, the exchange-traded structure, with its low fees, transparency, and pricing throughout the day, affords tremendous advantages. I cannot imagine a scenario where ETFs won’t surpass mutual funds in assets under management in the next decade or so. ETFs are just a far more investor-friendly product.
ETFdb: As popular as they have been, there have been some growing pains with investors and even some publications expressing frustration with these vehicles. What is the source of this frustration? Why have commodity ETFs been criticized?
SG: I think that you have correctly stated that there are growing pains. I’m not going to speak about leveraged products, because they have their own unique aspects. I don’t think a leveraged ETF product is suitable for a mainstream investor. You need professional investment advice to be toying with those products. By and large, for unleveraged commodity-based or futures-based ETFs, the first generation was structured based on the spot commodity futures and then rolled on the expiration of the futures contract. That has caused several issues that have been well publicized, primarily related to the impacts of contango and backwardation.
Essentially, contango is the cost of carry. If a grocer buys a can of peas and puts it on a shelf he has a cost, he had to lay out some money in order to store that can of peas, and as time goes on the price of the can of peas has to go up for him to make any money. That is just how it works with commodities. They are bought and stored, and until they get through the process of production to end use, there are costs involved from storage and processing.
This involves a price curve, which appreciates as you move out over time, all else being equal. It is very complicated to understand from an investment perspective. If you are just buying and holding a first generation fund or index - the spot month - and then rolling it, the negative and positive effects of the forward price curve will potentially have a dramatic impact on the investment.
The first generation of indexes and funds were truly innovative. They allowed investors with simple stock accounts to participate in commodity investments, which they would not have been able to previously do unless they had a futures account. Those are really smart products, but they were financially engineered. They were designed primarily by bankers and financial professionals to both provide a product to investors and to lay off some of their own risks.
Those first products came to market and were traded and people understood that it was great to have access to commodities markets, but there was probably a more efficient way to gain access. Then you get the next generation funds like Teucrium’s, where we design our funds specifically around the commodity. I think that investors really need to look hard at next generation funds and take into account some of what we have learned in the past about the inefficiencies of the first generation funds. There are now funds that are specifically designed around the commodity itself, and that address these issues of contango and backwardation.
ETFdb: Let’s talk about your products. As compared to a product that may invest in front-month futures, the Teucrium lineup generally spreads exposure across multiple maturities, meaning futures contracts maturing at different points along that curve you mentioned. How did you come up with this methodology for spreading exposure across certain commodities? What was the rationale behind structuring the products in the way that you have?
SG: We arrived at this structure from our commodities expertise. So first and foremost, we structured each product differently depending upon the commodity it represents. So take the Teucrium Corn Fund (NYSEARCA:CORN), for example. We knew we never wanted to trade spot prices because of several issues. Generally, spot month is most affected by contango and backwardation issues, and that obviously was a big issue for first generation funds that we wanted to avoid. Second, these are financial products settled to cash. We do not actually take physical delivery of the commodity, so there is really no need to trade spot. If you are not making or taking delivery, you are not ultimately setting the price for the commodity. And given that funds are just a vehicle through which investors can deploy assets into the space, these funds are not handling the commodities. They are not even in the commodities business; they simply represent the price of the commodity. That is a very important distinction: all Teucrium funds avoid spot. They are designed around the commodity themselves.
For instance, back to CORN, we trade second and third month futures because they will move with the nearby price of corn, which is what investors want to capture. But we also trade the December following the third month. For corn crops, that is very important because it represents the crop year. December represents the month that has the highest open interest and highest trading volume, affording very good liquidity. The reason for that is all of the Northern Hemisphere’s farmers, who grow the vast majority of corn, use that contract to hedge their crop.
If you have a knowledge of the crops and of the specific commodity, you can choose the contracts along the curve that most efficiently represent the price movements that will happen over an investor’s time horizon, which is usually between one and 18 months. Investors who want short-term trading horizons would do well to trade the first generation products that only hold the spot month. If you do not hold for an extended period of time where the contango issue can hurt you, those can be very effective vehicles for generating returns. But for an investor who wants to buy and hold a commodity, and has a view on it, they should look to these next generation products. That is what Teucrium designed these products for: they are liquid, they are transparent, but we design our products for people who are looking at their portfolio once a quarter, or once a year and re-allocating and making investment decisions.
ETFdb: Let’s finish up talking about CORN, which you just mentioned. I think a lot of people think of corn as something that goes on their dinner plate and not so much as an investable asset. But what is the investment thesis behind the Teucrium Corn Fund (CORN)?
SG: Coming from a background in commodities, we were stunned that there was no corn ETF. Corn is, in our opinion, the second most pervasive commodity in the global economy; besides energy, corn is everywhere. And most people do not realize that. So we chose CORN in order to get the investment vehicle out there, because it is a very important commodity to have within your portfolio allocation.
Our second reason behind introducing this fund was to prove our investment methodology to both Wall Street and investors, and of course CORN, in its first nine months, has been tremendously successful, so we know that our methodology is good.
We use the example of an SUV to illustrate how important corn is. If you take your SUV and pull it in to a service station, you will use about a bushel of corn in filling up your petroleum tank. And that is corn’s second biggest use.
Its biggest use is animal feed. So if you drive your SUV to the convenience store and buy that bag of beef jerky or a chicken taco, you are buying a product for which corn played a major role - in that its largest use is for feeding the animals that humans consume. Now if you get something to drink, it is probably sweetened with a corn-based sweetener, corn’s third biggest use.
The fourth-largest use is starches. So when you sign your credit card bill, that piece of paper is held together with corn starch. The safety seals on bottles - that thin layer of plastic - those are made from polymers that are derived from corn. There is no way to avoid contact with corn in your daily life. If you are participating in the global economy, you are a user of corn - and you probably don’t even realize it.
Disclosure: No positions at time of writing.
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