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).
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.
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