The Ultimate Commodities ETF Guide

May 08, 2009 9:59 AM ETUSO, GLD, DBO, SLV, RJI, DJP, GSG, GSP, DBC, LSC, RJA, RJZ, RJN, JJE, JJA, JJGTF, JJS, COW, JJM, JJP, DBA, DBB, DBP, DBE, PGM, JJCTF, UNG12 Comments
Don Dion profile picture
Don Dion
12.69K Followers

Commodities have received greater exposure in recent years thanks to a major bull rally in commodity prices coupled with new products designed to make these securities available to common stock investors. Many investors are familiar with precious metals and energy exchange-traded funds (ETFs), such as SPDR Gold Shares (GLD), PowerShares DB Oil (DBO), U.S. Oil (USO) and iShares Silver Trust (SLV), but they now have the option of investing in a variety of individual commodities and have a choice between several indexes that offer unique commodity weightings.

When oil prices rallied to $150 per share and corn prices advanced on ethanol demand, investors looked to grab a slice via ETFs and exchange-traded notes (ETNs). When commodities slid at the start of a major global recession, prices fell as much as 75 and 80 percent. Recently, several commodities have climbed off their lows, and some investors are starting to look at the sector in anticipation of an economic recovery. Commodities tend to outperform during the early phases of an economic expansion, when the rising demand outstrips the supply, due to recessionary cutbacks, and during the later stages, when demand again outstrips available supply. The point of this article is not to assess whether the economy is on the verge of a recovery—that’s a topic unto itself—but to compare the relative strengths of different indexes and investment approaches.

Any decision to invest in commodities should begin with the index funds. For the vast majority of investors, indexing makes the most sense. As with equity indexes, the securities providers have designed a plethora of ways to gain commodity exposure.

Broad Indexes. These commodity indexes offer exposure to the three subsectors—agriculture, energy and metals. The broadest of the broad indexes may be the ELEMENTS Rogers International Commodity Index Total Return ETN (RJI). According to the prospectus, the fund balances commodity consumption patterns across developed and developing countries. Its twenty agricultural components compose 34.9 percent of the index, ten metals compose 21.1 percent and six energy commodities make up 44 percent of the index. The nineteen-component iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP) invests 36 percent in agriculture, 30 percent in metals and 34 percent in energy.

iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) invests in the S&P GSCI Total Return Index, as does iPath S&P GSCI Total Return Index ETN (GSP). (The difference between the two funds is that one is an ETF and the other is an ETN.) Twenty-four components comprise these funds, of which 24 percent is in agriculture, 11 percent is in metals and 65 percent is in energy.

Finally, PowerShares offers the PowerShares DB Commodity Index Fund (DBC), the least broad index. It holds six components, two each of the three subindexes: 22.5 percent agriculture, 22.5 percent metals and 55 percent energy. All these funds charge 0.75 percent in annual fees.

Beyond the level of exposure to subindexes in each fund is the exposure to each individual commodity. Gold, for instance, ranges from 14.22 percent of RJI and 14 percent of DBC (though the index base weight is 10 percent) to 3.4 percent of GSG and GSP and 8.2 percent of DJP.

DBC has the largest trading volume among its broad-based commodity index peers, with well over a million shares trading on an average day. RJI, DJP and GSG have also proved to be liquid products, with average daily trading volumes of approximately 300K, 470K and 430K, respectively. GSP, while sharing the same index as its ETF equivalent, GSG, has failed to attract the same attention, with just 50K trading on the average day. DJP, GSG and GSP are created in 50K units, while RJI and DBC are created in 400K and 200K units, respectively.

Performance-wise, the difference between the weightings has led to divergent returns. Since October 2007, when the latest of these funds was introduced, DBC has been the best performer, down 31 percent, compared with a 49 percent drop for GSP. RJI and DJP finished in the middle but closer to DBC. Year to date, RJI is the best performer, up nearly 5 percent, while DJP and DBC are flat. GSG and GSP are down about 5 percent (through May 4). Assuming there is not a single breakout commodity that skews the indexes, these indexes will trade in the same general direction, and in the long run, the difference between them will be smaller than the difference with equity and bond funds.

Last but not least, ELEMENTS also offers a long/short commodity fund: ELEMENTS S&P Commodity Trends Indicator - Total Return (LSC). The fund is currently neutral on energy (it cannot be short energy) and long on grains, industrial metals, precious metals, cotton and sugar. It is short livestock, cocoa and coffee. The index uses a moving exponential average to determine whether to go long or short in each sector, and when it is neutral on energy, it distributes the weight “proportionately to the other five sectors.” The fund isn’t a hedged fund, however, that goes long and short at the same time—it could be all long or all short/neutral based on market conditions. Investors interested in more information should read the prospectus, which offers a detailed explanation of the index methodology.

The strategy paid off last year, and LSC rallied from September until December. Since its inception last July, LSC beat the other long indexes by 20 percent, with a return of just under 0 percent. It has underperformed this year because the fund is short in some sectors, causing it to miss the full effect of the rallies in March and late April. Compared to the other broad indexes, it is the worst performer in 2009, down more than 10 percent.

Sector Indexes. ELEMENTS and iShares shine in the sector index space. ELEMENTS offers investors the exact components of the broad index in the same proportional ETN allocations: RICI Total Return Agriculture (RJA), RICI Total Return Metals (RJZ) and RICI Total Return Energy (RJN).

iPath offers a suite of seven subindex ETNs: one energy (JJE), one broad agriculture (JJA) with three subsectors (JJG, JJS and COW), plus two metals (JJM and JJP).

PowerShares offers agriculture, base metals, precious metals and energy ETFs. (DBA, DBB, DBP and DBE).

Individual Commodities. Gold, silver, oil and natural gas were among the most popular single-commodity funds and were introduced around the same time as the broad indexes. More recently, iPath has introduced a suite of individual commodity ETNs filling in the gaps: four soft commodities, five industrial metals and platinum (PGM).

Two commodities gaining popular attention in recent weeks are copper and natural gas. iPath DJ-AIG Copper Total Return (JJC) rallied 50 percent this year, thanks to heavy buying from Chinese importers, though the rally may not last because Chinese thirst for copper is not insatiable. U.S. Natural Gas (UNG) is down 37 percent this year on weak demand, but it has been a topic of conversation among investors looking to pick a bottom in the commodity. From March 2 through May 4, U.S. Oil (USO) gained 25 percent, but UNG fell 15 percent, a difference of 40 percent. While it looks like an attractive divergence, crude oil demand is relatively inelastic, with most of the fuel going for transportation (70 percent). Thirty-four percent of natural gas goes to industrial demand, with another third to residential and commercial and a final third to electric power.

Leveraged Funds. Following the popularity of ProShares double-long and double-short equity ETFs, PowerShares launched a suite of ETNs based on the Deutsche Bank commodity indexes used for its ETFs. The ETNs replicate PowerShares ETFs with single- long funds, as well as single-short, double-long and double-short (the exception is gold; PowerShares does not offer a single-long ETN). One positive thing about the leveraged commodity funds is that the price movement of commodities has been less volatile. In the short term, the funds have sometimes traded such that the single-short outperforms the double-short, but over the long term, these funds have separated as expected. They still suffer compounding effects and the returns may deliver more or less than twice the leverage.

A big reason for the PowerShares funds’ strong performance is that they track the monthly performance of the underlying index, which itself has performed well because the Deutsche Bank Optimum Yield Indexes do not blindly roll contracts; instead, they select the contract that maximizes backwardation (futures are lower than the spot price) or minimizes contango (futures are higher than the spot price). ProShares uses the DJ-AIG indexes, also used by iShares, for its leveraged funds and offers double the daily change in prices, the same as for its equity funds.

If you’re an individual investor looking for commodity exposure but have little knowledge of the sector, stick with the broad indexes. Exposure isn’t necessary for a portfolio, but besides a play on an economic recovery, the broad indexes also offer inflation protection. The governments of the world can print paper currency on a whim, but they can’t print wheat, oil or copper.

This article was written by

Don Dion profile picture
12.69K Followers
Don Dion is the CEO of Inland Management, a company focused on acquiring, subdividing, developing and marketing large tracts of land on the fringes of major metropolitan markets. Inland Management has sold land in all 48 contiguous states totaling billions of dollars. As CEO, Don is responsible for helping to maintain and enhance the firm’s strong financial position and identifying opportunities for growth. In addition to his role at Inland Management, Don Dion is the Chief Investment Officer of DRD Investments, LLC. Based in Naples, FL. and Williamstown, MA., DRD Investments is a family office focused on managing a long/short hedge fund, real estate, venture capital and various other financial assets for the Dion family. Don also serves as the trustee of the Dion Family Foundation, which focuses on helping individuals with tuition assistance at Catholic Institutions for grammar school, high school, and college education. The foundation also helps individuals by supporting Massachusetts General Hospital. Don is on two leadership boards and advisory committees at Massachusetts General Hospital and the Home Base Program (a partnership between Mass General and the Red Sox Foundation). He consults with Saint Dominic's Academy and serves as a trustee of Saint Michael’s College. Previously, Don was the founder and CEO of Dion Money Management, a fee-based investment advisory firm for affluent individuals, families and non-profit organizations. Founded in 1996 and based in Williamstown, MA. and Naples, FL., Dion Money Management managed approximately one billion in assets for clients in 49 states and 11 countries. While at Dion Money Management, Don was responsible for setting investment policy, creating custom portfolios, and overseeing the performance of client accounts. Don sold the firm to NYC-based Focus Financial Partners (FOCS) on September 1, 2007 and no longer manages money for other families or institutions. Don remains a shareholder of Focus Financial Partners (FOCS). Don is also the retired publisher of the Fidelity Independent Adviser family of newsletters, which provided a broad range of investor commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With nearly 100 thousand subscribers in the United States and 29 other countries, Fidelity Independent Adviser published two monthly newsletters and one weekly newsletter. The flagship publication, Fidelity Independent Adviser, was published monthly for 16 years and reached over 60,000 subscribers. In 2011 Don and his daughter Carolyn co-authored the Ultimate Guide to ETFs, available on Amazon.com. Prior to founding Dion Money Management, Don co-founded Litchfield Financial Corp. (LTCH) with Summit Partners. Don served as Chairman and CEO of Litchfield, which was listed on the Nasdaq in 1992 and acquired by Textron Corp. (TXT) in 1999. Don was also the Executive Vice President, CFO and General Counsel for Patten Corporation (BGX) from 1986 to 1988, where he played a critical role in the company’s successful initial public offering on the New York Stock Exchange. From 1983 to 1985, Don was a corporate lawyer with the Boston Law Firm of Warner and Stackpole. Before joining Warner and Stackpole, Don worked as a C.P.A. for Ernst and Young from 1979 to 1983. Don graduated with honors from Saint Michael’s College in 1976 with a B.S. degree in Economics and Business Administration. He received his J.D. from the University of Maine Law School in 1979 and his LL.M. from Boston University Law School in 1982. Don can be reached at donalddion@gmail.com

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