A panel of industry executives discuss the recent controversies surrounding commodity ETFs.
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By John Gabriel | 01-20-10 | 06:00 AM | Email Article

An interesting mix of industry players sat on the aptly titled panel, "Hot Topic: Commodity ETFs," at the third annual Inside ETFs Conference, hosted by indexuniverse.com. These days it is no understatement to render commodity ETFs as a "hot topic." In fact, it's hard to think of an asset class that the ETF industry has had more of an impact on in the last several years--both through democratization and regulatory issues that have arisen. It wasn't long ago that the commodities futures markets were solely the domain of farmers, energy producers, and mercantile-exchange arbitragers. Today, with the advent of futures-based commodity funds, we've witnessed monthly financial activity in the commodity markets that considerably outstrips physical production. (Also, speaking of regulation, on Jan. 14, the Commodity Futures Trading Commission ruled 4 to 1 in favor of enforcing position limits on several energy futures contracts; see the closing remarks press release).

John Gabriel is a strategist on the passive funds research team for Morningstar and head of Canadian exchange-traded fund research.

First up on the panel was Satch Chada, managing director at Jefferies Asset Management, who advocates that investors allocate the "commodity slice" of their portfolios to the stocks of commodity-producing companies, rather than commodity futures. This is along the same school of thought that brought us Market Vectors RVE Hard Assets Producers ETF   from Van Eck. Teaming up with Thompson Reuters, Chada's firm introduced CRB Global Commodity Equity , CRB Global Industrial Metals Equity  , and CRB Global Agricultural Equity  in September 2009.

The argument, of course, centers on the recent deviation in performance between spot prices and the returns that investors experienced in long-only commodity futures index products. I strongly urge interested investors to check out the recent article by my colleague Paul Justice, "Commodities Are a Rock in a Hard Place," for his thoughts on what might be contributing to the seemingly persistent state of contango that has been so prevalent over the past few years in most major commodity markets. This dilemma can be more easily communicated graphically, in my opinion. Notice in the chart below how the Dow Jones-UBS Commodity Spot Index begins to significantly outperform its futures-based cousin, Dow Jones-UBS Commodity Index, as asset growth in futures-based ETFs begins to ramp up around 2005. (Note that the "futures-based" version of the index is the benchmark of the popular  iPath Dow Jones-UBS Commodity Index ).

 

A few trends are worth highlighting from the graph. First, although the spot price index returned 214.5% over the past 10 years (2000 through 2009), the futures index--which serves as the benchmark for "investable" products--only posted a gain of 50.8% over the same period. You probably also noticed that backwardation in the energy markets helped the futures index outpace spot price returns until around 2005--right around the time when passive long-biased commodity ETFs started gathering assets.

To help illustrate the potential impact that wide-scale adoption of commodity ETFs had on commodity futures markets, consider that from Dec. 31, 1999, through 2005 year-end, the spot index gained 117.7% versus 85.5% for the futures index. However, from Dec. 31, 2005, through the end of 2009 (after commodity ETFs gained in popularity), the spot index rose more than 44%, compared with a decline of nearly 20% in the futures index. Sure, the return patterns remained correlated, but I highly doubt that any investor would find such results appealing (or acceptable) by any stretch of the imagination.

Getting back to the panel; we'd note that Chada's argument does fly in the face of why investors gravitated to commodities so strongly in recent years. Commodities' appeal stems from their diversification benefits (as a noncorrelated asset) when added to a portfolio of equities and fixed income. However, by investing in the stocks of commodity-producing firms, investors are thereby simply piling on additional "equity beta" to their portfolios.

While we acknowledge that many have questioned commodities' role as a "diversifier" following the crisis of 2008, we'd also remind investors that the correlation of returns to historically uncorrelated assets goes to one amid a deleveraging crisis. Of more interest to us is the possibility that the rising popularity of commodity investing among the masses could actually help diminish the asset class' diversification benefits. In any case, to Chada's and his firm's credit, the timing of the pitch really couldn't be better--at least in terms of resonating with those who feel burned after witnessing how contango can erode their investments in commodity futures.

As expected, John Hyland, CIO of United States Commodity Funds, who is never shy to share what's on his mind, defended commodity futures' investment merit and their role as part of a broadly diversified portfolio. When evaluating the research presented to rationalize each panelist's stance on the topic, let's not lose focus on their primary business objectives. Of course, Hyland's firm offers the now-infamous (futures-based)  United States Oil  and  United States Natural Gas . These funds have spent a lot of time in the headlines recently on account of their rapid growth coinciding with steep contango in the energy markets. Click here to see a video clip of Hyland discussing the CFTC's recent ruling on position limits and how it affects his firm's operations.

We estimate that about $1.5 billion in shareholder wealth was wiped out in UNG during 2009 thanks to the effects of contango. Interestingly, investors continued to "bottom fish" natural gas via the fund, helping UNG clock in as the fourth most popular ETF of the year in terms of net inflows. Even as spot prices on natural gas ended up even for the year, this fund lost 57% due to the effects of rolling the futures contracts each month.

Barring a wide-scale shift in how investors gain access to commodities, contango seems to be a problem that could persist well into the future. Let's face it, financial players won't be taking physical delivery of most commodities and assuming the (massively prohibitive) associated storage costs. Moreover, as shown in the graph above, long-only futures-based commodity index investments have started to reach a critical mass, and their influence on the behavior of the asset class cannot be ignored by those looking to add commodity exposure to their portfolios. Regulators--for better or for worse--aren't standing pat. Of course, we'll continue to monitor the situation as it unfolds. (As a rule of thumb: If the terms contango and backwardation mean nothing to you, then by all means steer clear of futures-based investment solutions.)

Fresh off the Jan. 8 launch of ETFS Physical Platinum Shares  and ETFS Physical Palladium Shares , we also heard from Graham Tuckwell, chairman of ETF Securities. Tuckwell's firm now enjoys the coveted first mover advantage status with PPLT and PALL, which, as of Jan. 13, already had $126.1 million and $38.1 million in total net assets, respectively--talk about pent-up demand. Considering the recent poor investor experiences in derivatives-based funds, the warm reception for these physically backed funds really came as no surprise to industry followers.

Still, these recent ETFs are precious-metals funds. Keep in mind that because we can account for and (easily) store precious metals, their futures contracts will always equal the spot price plus interest (with interest expenses varying based on how far out the contract matures). Obviously, because of storage constraints, energy markets are a much different animal.

Realizing the appeal of physically backed commodity exposure in the marketplace today, Tuckwell and his firm have--still unsuccessfully--explored the possibility of launching a physically backed energy ETF. As nearly all of the above-ground oil and natural gas is owned by the major integrated oil firms at their refineries, ETFS was interested in attempting to securitize those refinery assets. Tuckwell even revealed that his firm has held discussions with  Royal Dutch Shell  about the idea. Details are scant at this point, but it will be interesting to see if these creative folks can discover an acceptable process for securitizing refinery assets down the road.

We can argue all day long about when or whether we'll see commodities markets flip into backwardation (like oil for much of the period between 2000 and 2005). If that were to happen, head winds would turn to tail winds, and futures-tracking products would outperform spot prices. While it seems very unlikely at this juncture, if we've learned anything over the past couple of years in capital markets, it is that unlikely events seem to occur more frequently than anyone expects. For the time being, however, we'd expect purveyors of physically backed commodity funds to have a decided leg up on futures-based products that offer exposure to similar markets. When possible, we'd urge investors to take the physically backed route and avoid singing the contango blues.

 

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