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PowerShares Commodity ETF Remains a Top Choice

Although commodities have struggled recently, this ETF is a good choice for investors optimistic about the sector.

Morningstar Fund Analysts, 04/05/2013

Commodities have had a rough start in 2013, remaining stagnant as equities experienced a strong rally. A weak growth outlook in Europe, the anticipation of slowing infrastructure-related spending in China, and excess supply were behind the lackluster performance. In the first two months of the year, investors pulled assets out of the large, broad commodity ETFs as prices remained stationary or declined, but PowerShares DB Commodity Index Tracking DBC bucked the trend and took in more than $300 million in new assets. Unlike most sector ETFs, which are relatively similar to each other in construction, commodity fund methodology and strategies can vary widely. Investors continue to be drawn to DBC for its diversification and dynamic rolling, which have helped it produce the most consistent risk-adjusted return of its peer group. DBC is a solid choice for investors who think now may be a good time to add some commodities exposure.

DBC provides exposure to 14 commodities from four sectors: energy, agriculture, industrial metals, and precious metals. Many commodity funds weigh constituents by economic importance, resulting in a heavy energy overweighting, but DBC is well-diversified across commodity sectors by mimicking open interest, making it a true broad-basket commodity fund. In addition, energy prices are relatively more volatile than other commodity products, so DBC is slightly less volatile than commodity funds with a large energy exposure.

Broad-basket commodity products will likely interest two kinds of investors: those who believe global demand for commodities will grow in coming years, and those seeking diversification and an inflation hedge. Investors interested in growing worldwide demand for commodities should keep an eye on demand from China, India, and the rest of the emerging markets. As an inflation hedge, commodities usually underperform in periods of low inflation and outperform when inflation is high, allowing investors to maintain their purchasing power. Generally, commodities shine at the beginning of a recession and at the end of an economic expansion. As for risk, commodities are a high-volatility asset class. Over the past five years, DBC has exhibited almost 25% more volatility than the S&P 500.

Historically, commodities have been only slightly correlated to stocks, but that relationship has grown more correlated in recent years. Since the financial crisis, commodities have performed in tandem with the equity market: DBC's index was almost 80% correlated with the broad U.S. market over the past three years. When stocks start to decline, commodities are unlikely to keep a portfolio afloat. Because investing in commodities has been effectively democratized through products like DBC, it is unlikely that correlations will return to previous low levels.

How the Portfolio Works
Instead of purchasing physical commodities, DBC tracks an index of commodity futures. Commodity futures are obviously much more practical than storing physical commodities, but they come with their own peculiarities and potential downsides. Some divergence from the underlying commodities’ spot prices is inevitable, especially over the long term. Futures contracts are agreements that require the holder to purchase a certain quantity of a commodity, at a predetermined price, to be delivered on a specific date. The total return of this fund’s benchmark index includes the sum of the price movements of the contracts, the positive/negative roll yield, and the hypothetical return that would occur from investing the cash collateral of futures contracts in Treasury bills.

Physical delivery of a commodity occurs when its futures contract expires. To prevent taking these deliveries, DBC rolls its contracts, which means selling contracts close to expiration and buying a contract of the same commodity with a further-off expiration. If the longer-dated contract is priced higher than the expiring one, the fund will be negatively impacted by contango, or negative roll yield. If the opposite occurs and the longer-term contract is priced cheaper, this is called backwardation and the fund earns a positive roll yield. In a state of contango, the fund incurs a loss even if the price of the underlying commodity that day (spot price) doesn't change, as it replaces lower-priced contracts with higher-priced contracts. Energy commodities have been particularly susceptible to contango in recent years. In 2012, an investor tracking front-month natural gas futures would have taken a significant loss even as the spot prices rose, solely because of the contangoed market.

DBC employs a dynamic strategy to minimize contango. When a futures contract is up for expiration, the index is able to roll into any contract that expires within the next 13 months. The index picks the contract that minimizes negative roll yield. This methodology also reduces the number of rolls that occur every year, keeping brokerage costs down.

DBC is a limited partnership, so investors will receive a K-1 form instead of a 1099 during tax season. K-1s can be complicated and time-consuming. At year-end, DBC must mark to market its futures contract holdings, which in the eyes of the IRS is equivalent to selling them. Any gains made over the course of the year will be realized and passed through to investors. Each year, 60% of the gain will be taxed at the long-term capital gains rate, and 40% at the short-term rate, whether or not the investor has actually sold the fund. Gains made by the industrial metals-related contracts in the portfolio (12.5%) are exempt from this rule.

Morningstar fund analysts cover more than 1,700 mutual funds and write regular commentary covering fund industry news, fund investing trends, picks, portfolio planning, international investing, and more.

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