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Taking a Fresh Look at Equity Commodity Funds

The old guard may offer some overlooked attributes.

Kevin McDevitt, 03/27/2012

Investors' interest in commodities has exploded over the past 10 years. Whether they're looking for diversification, an inflation hedge, or to speculate on rising prices, investors have plowed hundreds of billions of dollars into commodity-related offerings, both mutual funds and exchange-traded funds. A decade ago, commodity-related funds (at that time, only the open-end equity energy, precious metals, and natural resources categories existed) held just $10 billion in assets. Today, after gold has soared to $1,650 an ounce from $300 and oil has gone from less than $30 per barrel to north of $100, total assets in ETFs and open-end commodity-related funds hit an astonishing $320 billion in February.

Yet, it remains debatable whether the average investor even needs dedicated commodity exposure. Most equity investors already get a fair amount of commodity exposure through energy and materials equities. Those two sectors claim a combined 15.6% of the S&P 500 Index. The counter argument is that a small commodities weighting offers diversification benefits, but rising correlations in recent years potentially diminish those benefits. Neither do commodities always provide a perfect hedge against inflation or a falling dollar. That was the case for oil versus a weak dollar in the 1980s and gold versus inflation from the mid-1930s through the 1960s. (Not coincidentally, though, gold prices have soared since the U.S. went completely off the gold standard in 1971.) More broadly, we are currently 13 years into a commodity bull market. Despite calls that this time it's different and that resources will be permanently constrained, similar things were said during the last commodity boom in the 1970s and early 1980s. Human ingenuity has confounded such predictions in the past and there's always the potential for prices to revert to the mean.

But for those still interested in dedicated commodity exposure, it may be worth considering old-fashioned commodity equity funds. That's heresy in some circles these days as newer, more-targeted options have become the rage. But that consensus potentially creates a contrarian opportunity for equity commodity funds, especially in light of recent fund flows. While funds offering more direct exposure to commodities, which we briefly describe below, certainly have their benefits, they may not be the best option in all cases. Equity commodity funds (whether mutual funds or ETFs), on the other hand, offer several advantages, particularly for those investing taxable dollars.

Three Pipelines to Commodity Exposure
First, some background on the space and the different ways investors can gain access to it. There are three primary ways to invest in commodities and a bevy of funds specializing in each method. Equity funds invest in the shares of companies involved in extracting and processing raw goods with company balance sheets and related cash flows providing the conduits for exposure.

Other funds take a more direct approach and invest in derivatives that lock in exposure to the price movements of the underlying commodities. These funds typically track a commodities index such as the broad-based Dow Jones-UBS Commodity Index. They then collect interest income from the bonds, such as T-bills or Treasury Inflation-Protected Securities, which are used as collateral for the underlying derivatives. These funds can also potentially earn positive roll yield through their contracts. (Last year my colleague Abraham Bailin thoroughly reviewed different commodity vehicles, as well as the dynamics of roll yield.) Finally, there are ETFs that buy the actual commodity itself, such as SPDR Gold Shares GLD, which owns physical gold. This eliminates the potential risks that come with investing in gold miners, which have been notorious historically for poor capital allocation. But funds that own physical commodities are generally limited to precious metals with high value/size ratios. Overall, for someone looking for commodity exposure, these vehicles offer retail investors, and even institutions, a targeted means of doing so.

With prices rallying, many commodity funds have had the wind at their back over the past 10 years. Equity commodity funds (that is, those investing in oil & gas, mining, and agricultural companies) have performed the best, with those focused on precious-metals stocks gaining a monumental 18.7% annualized through February, making it the best-performing category overall during that stretch. The broad-based natural-resources category, whose funds typically hold two thirds of their assets in energy stocks and the remainder in materials, didn't quite match the precious-metals category, but still delivered an annualized 13.1% return, trouncing the S&P 500 Index's modest 4.2% gain. These two categories also beat the Dow Jones-UBS Commodity Index's 7% return. Although open-end, commodity broad-basket funds have not been around as long, that group has performed a bit better than the index over the past five years, falling 1.3% annualized versus a loss of 1.8% for the DJ-UBS bogy. Still, that was well behind the natural-resource category's 4.1% gain.

With such impressive results, one would think that dough would be rolling into equity commodity funds. But investors have shown a clear preference for the pure-play mutual funds and ETFs that invest in commodity derivatives and physical commodities, such as the wildly popular SPDR Gold Shares. Investors have deposited just $14.9 billion into the three categories of open-end equity commodity funds over the past three years versus $33.9 billion for commodity–broad basket funds. ETF equity commodity funds have fared better with $25.7 billion in inflows. But that still trails the $31.3 billion that has gone into commodity derivatives and physical commodity ETFs. ​

No Perfect Solution
Clearly direct commodity exposure is winning out with investors, but every method has advantages and shortcomings to be aware of. Natural-resources stocks are considered imperfect commodity proxies because while company results and stock prices are linked to commodities, other factors also play a role. For instance, even though they have lower correlations with the broader equity market (that's especially true for precious-metals shares) than most stocks, they sometimes seem more driven by equity markets than commodity markets. There's also operating leverage, which tends to make equities even more volatile than even the commodities themselves. (This owes to the high fixed costs associated with getting the resources out of the ground. As prices shift, individual projects can suddenly become profitable or unprofitable, leading to big swings in share prices.) Finally, there are other company-specific factors such as business and management risk that don't exist when investing directly in commodities. So, investing in companies involved in extracting and processing commodities involves more variables and volatility than investing directly in commodities.

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