Commodity investing is a tricky business. Do you invest in the commodities themselves, the producers or the infrastructure?
And do you opt for an active manager or a passive investing approach?
For many, commodity exposure is a small part of their portfolios and therefore a passive approach can make sense, particularly with many espousing the well-worn argument of lower costs on exchange-traded products and tracker funds.
But once a passive approach has been decided upon, there are yet more decisions to make, which are dependent on what the investor or client actually wants to achieve. It is not always as simple as picking an exchange-traded fund (ETF) over an exchange-traded commodity (ETC) or an index tracker fund.
ETFs fall under the Ucits rules that require a diversified basket of assets, while ETCs are security-based vehicles with counterparty risk. The latter gives exposure to just one type of asset such as oil, gold, platinum or wheat.
The choice of vehicle, however, is perhaps less important than what you want to get from the exposure – for example, is it a trading position or a buy-and-hold asset allocation move?
Michael John Lytle, chief development officer for Source, argues that passive exposure to the commodities market is a good way of expressing a view on a market, providing the investor is not looking to actively trade the position in the short term.
“Passive is a very good way of expressing that view if you’re comfortable with the fact that this is a view you’re taking for the long term and accept the value of the investment will rise and fall over the short term.”
He adds: “The price of commodities tends to be relatively volatile in the short term and there can be quite a lot of surprises.”
David Mazza, vice president and head of research for SPDR ETFs and SSgA funds at State Street Global Advisors, notes the benefits of a passive approach include low costs, greater transparency and more liquidity.
“Additionally, passive options include covered call strategies, advanced optimal yield techniques, and the ability to long or short a particular segment based on momentum and the structure of the futures curve,” he explains.
The effect of the futures curve and the process of rolling futures contracts when accessing commodities is a key issue for investors, as it does not always reflect what is happening with spot prices.
Andrew Walsh, head of UBS ETF sales UK & Ireland, UBS Global Asset Management, points out in 2009 broad commodity spot prices gained roughly 50 per cent in aggregate. But investors buying broad commodity futures only made roughly 24 per cent.
“The reason for this is that spot prices are doing one thing, but to keep exposure to [that] commodity you have to roll futures contracts and that rolling process can cost a lot of money.”
For example, if you want to maintain exposure to a commodity following the expiration of a futures contract, but the next contract is higher than the spot price, that will gradually erode returns as the market is in contango. The reverse of this phenomenon is called backwardation.
“If you’re in backwardation you get massive benefits, but the simple fact is that across all commodities they wouldn’t all be in contango or backwardation, you’d have a combination. In 2009 there was an appalling mix of contango and backwardation, and that’s when it starts to massively erode your returns,” explains Mr Walsh.
“Therefore when you’re investing in commodities, trying to buy into an index [or vehicle] that tries to mitigate this roll yield is massively important, perhaps even more important than what you’re buying.”
Of course, ETFs and ETCs are not the only options for passive investors. There are also passive funds that track indices of energy producers, oil service companies, or those involved in the infrastructure surrounding commodity production.
Even though commodity prices are lingering at lower levels, there seems to be a sense of growing optimism among investors, with some looking to cautiously dip their toes into the commodity waters. Research from ETF Securities notes that long WTI (West Texas Intermediate oil) ETPs “have experienced the longest streak of inflows to date as bargain-hunting investors seek to benefit from the considerable upside to the price from current depressed levels”.
Nyree Stewart is features editor at Investment Adviser
THE FUTURES CURVE
Andrew Walsh, head of UBS ETF sales UK & Ireland at UBS Global Asset Management, explains:
“The performance of many first-generation broad commodity indices can suffer particularly from the impact of ‘negative roll yields’. The issue being that investors can find it very difficult to participate properly in what the spot commodity prices are doing when accessing commodities via futures-based indices.
“Simply put, contango is where the price of the futures is higher than the current futures contract. Backwardation is the opposite, where the futures price is lower. Obviously, if futures were always being rolled when in contango, it would get very expensive and exacerbate the negative roll yield. For example, selling something at $100 and having to buy it back at $110 to keep the same exposure gets very expensive.”
ACCESS FOR INVESTORS
David Mazza, vice president and head of research for SPDR ETFs and SSgA funds at State Street Global Advisors, points out the three main ways of passive investing are through…
• Physically-backed ETFs – usually only precious or industrial metals;
• Futures-based funds that focus on agriculture, energy and metals;
• Equity-based companies that produce, transport and/or store raw commodities.
He explains: “The differences between these three ways of access are significant. Physically-backed ETFs allow investors to trade at or near spot prices. The return consists of a single factor – a change in price – and these ETFs are nearly perfectly correlated with the metal they track.
“The returns of futures-based products are related to changes in the price of futures contracts and roll yields. The change in the price of the futures contract may or may not be correlated to the underlying commodity.
“With companies that produce, transport and/or store raw commodities, returns are based on the change in price and dividend yield. The change in price may or may not be correlated and depends on the health of the underlying company, sector, earnings stability [and] growth.”
EXPERT VIEW
John Adu, head of UK exchange-traded product distribution, Deutsche Asset & Wealth Management, says:
“Depending on the individual investor’s preference, each passive tool has its own benefits. Commodity ETFs and passive tracker funds offer exposure to broad-based, diversified commodity indices, allowing the investor to generally invest in the commodities market, and ETFs offer the additional advantage of allowing for intraday trading.
“ETCs on the other hand allow investors to express specific views on commodities sectors, like energy, or individual commodities, such as oil or gold and, like ETFs, can be entered into and exited within the same trading day.”
