Additionally, readers inquired about just holding individual equities in the energy sector vs. holding a diversified commodity fund with energy as a component. These are interesting strategies for a number of reasons. However, it does have its issues and warrants a tough look at the individual portfolio dynamics and the investor’s true objective.
Let’s say you have a portfolio of individual equities and among your holdings are the likes of Exxon Mobil (XOM), but not the ConAgras' (CAG) of the world. Also, your portfolio happens to keep a relatively strong correlation to the S&P 500. In this simple case DBA would be a shoo-in for portfolio diversification with a correlation of .20 and Beta of .20 against the S&P 500.
Even better, Exxon Mobil has a Beta of 1.16, so with a close to equal weight of XOM you would moderate its company specific risk. Remember, we are assuming your objective is to try and gain access to the oil and natural gas sector through Exxon Mobil. You may have accomplished this to an extent, but this is where things start to get a bit more complex. You are also carrying exposure to other commodities, like chemicals, and you have become involved in electric power generation, the refining of oil and the transportation of various other energy commodities. Further more, you are exposed to company specific risk, like missed earnings or accounting irregularities.
At this point we start to question the merits of purchasing an individual equity or small group to serve proxy for a sector or commodity. Would it not be better to substitute in a sector fund, like (IXC) or (IYE). XOM happens to carry a 17.6% and 23.14% in each of the funds, respectively. At least you are diversifying away many of the same risks present in holding the individual equity.
By holding XOM directly, the investor is choosing XOM on its merits alone and believes this will be the best performer out of its competitors, sector, and potentially the commodity it produces.
Don’t get us wrong. We make these choices in a concentrated portfolio, which aims to shoot the lights out, but not in a portfolio which is trying to achieve a high level of diversification. What about wrapping a commodity based fund with energy as a component? Here you have an issue of overlap and potential over concentration. In this case XOM revolves mainly around natural gas and oil, which figure prominently in both DBC and DJP. However, one advantage of employing this strategy could be to hedge against a company’s specific risk while not plowing your entire designated commodity exposure into a few companies.
A case in point is Enterra (ENT), a Canadian oil and natural gas trust, which faces both company and government specific risk. The one bright spot of commodity stocks is their potential ability to remove a large portion of Contango risk, which the pure commodity funds face in the futures market. We can also envision working down a huge concentration in XOM over time in order to minimize potential tax implication and rolling the proceeds into a diversified commodity fund.
In short, there are countless scenarios and strategies to the above questions. We seem to have wandered, a bit aimlessly, through a few. In the end, for a diversified portfolio, we recommend the pure play. It seems that the commodity-based funds are an easier solution for overall portfolio management and segregation of risk.
Should you choose to start mixing and matching, we encourage you to review your actual purpose and do the detailed analysis of the holdings' effect on the portfolio. Additionally, a new site, Hard Asset Investor might help explain additional strategies or investment vehicles centering on commodity assets. It is worth a visit.