Commodity Exposure Via ETFs: A Fund Manager's Process

Includes: DBC, DJP, GSG, GSP
by: Keith Lenger

We continue to evaluate our commodity-based investment vehicles. The backbone of our firm manages diversified portfolios, so the balance of this article will revolve around finding the appropriate fit for those portfolios in our allocation model.

It was roughly 4 years ago that we looked into adding commodity exposure to our portfolios. At the time, the only real solution we arrived at was either the PIMCO Commodity Real Return Strategy Fund [PCRAX], buying and selling actual futures or piecing together various stocks or single commodity funds. At the time we decided not to move forward with either solution, as we felt the expense of paying a broker load plus the funds internal expense (call it a fundamental flaw) or the cost required to trade commodities futures was to steep for us and our clients. How things have changed over the last 4 years!

As the ETF revolution began to gain momentum and commodities became in vogue with the run in oil, we started our hunt a new. PowerShares DB Commodity Index ETF (NYSE:DBC) caught our eye when it hit the exchange on February 2, 2006. For our diversified portfolios it seemed to fit the bill. 6 broad based commodity sectors, which hold significant importance on the world stage.

The only issue we had was the high exposure to energy at 55%. On the flip side, the fund offered a low management fee of .75% and the ability to trade during the day. This was a great expense and management improvement over the previous alternatives. Additionally, they seemed to have moderated the issue of contango through their strategy of ”Optimum Yield”. Needless to say, we promptly added it to our portfolios.

We didn’t have to wait long before the revolution turned into an onslaught of commodity ETF and ETN offerings. The few that we contemplated were iPath Dow Jones-AIG Commodity Index Total Return ETN (NYSEARCA:DJP) (6/6/06 inception), iPath S&P GSCI™ Total Return Index ETN (NYSEARCA:GSP) (6/6/06 inception) and iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG) (7/10/06 inception).

Furthermore, there are some serious differences between both ETF’s and ETN’s. We found this site does an excellent job of comparing the two. The main issue for us was the bonus of removing the tracking error with the ETN. Typically, this does not provide such a large issue. However, we had heard a few stories about getting killed while selling during the most recent market down draft. In this case the rapid build of shares (supply) really pushed down the ETF price causing a significant decoupling from the intrinsic value of the under lying commodity pool. In our view that seriously negates the ability to sell during the day. Accordingly, we decided to knock out GSG, an ETF vs ETN.

This left us with our original DBC holding and the choice between GSP and DJP. It was easy for us to choose between GSP and DJP - the energy weight of GSP is 70% with roughly 46% being exposure to crude oil. DJP offers a more balanced exposure to all commodities with a specific increase in agricultural goods and metals. Thus, we removed GSP from the running and added DJP to the portfolio.

Allow me the opportunity to digress here, momentarily. Conceptually, we like the idea of having greater exposure to agricultural goods for a few reasons. It is our belief that there will be further pressure on agricultural goods derived from the growing populations of China and India. We theorize that as these populations continue to industrialize and gain greater disposable income, they will simply eat more. This coupled with the green environmental movement will further add to the strain on certain agricultural goods. As more corn is demanded for ethanol, fields we be converted and potentially cause shortages in other agricultural goods, similar to the crowding out effect on the bond market. Of course, the flaw being a fixed supply of farm land. A very suspect Malthusian argument. The coup d’état, we are pushing it here, being global warming and a more unstable environment for agricultural production. Alright, back to the main issue at hand.

Here it is, with a neck and neck run to the finish line. Unfortunately, we are going to have to hold you in suspense for a bit. We still hold both DBC and DJP. We will leave you with this. We are strongly considering removing DBC from the portfolio and, from time to time, adding OIL. Why add oil when we have actively worked to lower the exposure to energy, specifically oil, in the investment vehicles we have chosen? Frankly, we don’t have the resources to monitor and trade the various commodities, but we can track oil. If we structure our commodity segment in this regard, we gain a bit more control over the weighting and exposure to oil. What we are still researching is the issue of Contango management.

In the end we think having a weight in commodities is essential to creating a diversified portfolio. The issues described above are our main concerns. We encourage all those to contemplate further the other aspects of these asset classes, such as, lower asset correlation and reduction in portfolio standard deviation. As always, we will keep you posted on our final resolution between DBC and DJP.