By Stephen D. Simpson
Although the concept of "hedging" has been stretched, abused, and otherwise manipulated over the years, it is nevertheless a very important process for many companies. Commodity producers use forwards and futures contracts to help ensure a certain level of cash flow, and corporate commodity consumers use hedging to help control costs. So here's a thought - can regular people use commodity investment products like ETFs to hedge some of their everyday costs of living?
Yes … Maybe
In theory, this can work. If the price of gasoline futures, hog futures or corn futures rise, those movements do ultimately reach your wallet. So there's a certain logical sense to offsetting those impacts by holding shares in instruments that would do well in those environments.
Take the case of gasoline. The average U.S. household spends more than $4,000 each year on gasoline and just a 10% increase in prices at the pump represents a noticeable chunk of disposable income for many people. The United States Gasoline ETF (NYSEARCA:UGA) had climbed about 27% over the last year, while nationwide average gasoline prices were up about 11%. The idea here is that you could calculate your expected annual gasoline purchases, buy a similar amount of UGA shares and come out more or less even - if gasoline prices rose, you'd pay more at the pump, but you should see higher prices on UGA shares (and vice versa).
And perhaps it doesn't have to just be gasoline. Could an agriculture-heavy ETF or ETN like DJ-UBS Agriculture Total Return Sub-Index ETN (NYSEARCA:JJA) or Rogers International Commodity Agriculture ETN (NYSEARCA:RJA) offset the price hikes that companies like Tyson (NYSE:TSN), Kellogg (NYSE:K), and Kraft (KFT) have pushed through at the supermarket?
… Or Maybe Not
Unfortunately, there are a lot of obstacles and drawbacks to this idea.
First, there is considerable tracking error to consider. Not only do commodity ETFs that buy futures contracts experience tracking error, but even ETNs aren't immune when it comes to the differences between commodity prices and "real life" prices. While the performance of the gasoline ETF and average pump prices do generally travel together, there's considerable over-shooting with futures and a futures-owning ETF. What's more, gasoline is a regional market - your experience at the pump in Texas won't be the same in California or Vermont.
Along similar lines, agricultural commodity movements don't necessarily match up with supermarket prices. Corn prices can jump tomorrow, but the price of your corn flakes isn't likely to change overnight. Not only is there a lag in how commodity prices translate into store prices (and there's more to store prices than just commodity costs), but every food company has its own set of options - sacrificing/expanding margins, engaging in their own hedging programs, and using ingredient substitutes, etc - for dealing with commodity price changes.
So here we have a problem with both magnitude and timing. Higher sustained prices for cattle, hogs, or wheat will indeed eventually reach the products of your local store's shelves, but there's going to be a significant (and inconsistent) difference in both timing and magnitude. Your agriculture ETF/ETN may outperform today (while food inflation is low) and then underperform right when you start noticing the changes at Walmart (NYSE:WMT).
Other Issues To Consider
Tracking error and volatility may be the biggest problems, but they're far from the only challenges to hedging your living expenses in the market.
For starters, this sort of idea requires you to set aside money that could otherwise go to productive long-term investing. With most Americans already failing to save anything close to enough for retirement or emergencies, setting aside $4,000 to offset gas prices is probably a non-starter for most people.
Taxes and expenses are another issue to consider. Unless you select ETFs/ETNs and brokers that permit commission-free trading, you're going to have to pay each time you buy or sell. Likewise, taxes could chew up a significant part of your gains if you look to trade frequently. And if you don't trade, you still find yourself in a situation where your monthly disposable income varies with those price changes.
An Alternative Approach
Instead of thinking about commodity ETFs (or any investment, for that matter) as a way of recouping what you spend in your daily life, it is probably better to appreciate them for what they do offer - a convenient way to translate an opinion about the market(s) into an investment/trading opportunity. There's nothing wrong with selecting ETFs based on a thesis that commodities prices are heading higher (or lower), and there's likewise nothing wrong with trading them.
When it comes to your daily expenses, though, these ETFs look like pretty blunt instruments. While you can use a rock to drive a nail, it's really not a good idea. Likewise, while hard-working investors probably can use ETFs, ETNs and futures to offset their commodity-linked living expenses, it's not at all easy, it does carry risk, and it's probably a better use of time and money to keep day-to-day budgeting and investing separate.
Disclosure: No positions at time of writing.
Disclaimer: Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets. Read the full disclaimer here.