A panel of industry executives discuss the recent controversies surrounding commodity ETFs.
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 news release).
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
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.