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A Commodity ETN with Brains

Scott Burns

Scott Burns: Hello, I'm Scott Burns, director of ETF analysis here with Morningstar. We thought we'd take a little break from reporting on the market turmoil to talk about asset allocation.

We're thinking investors can't take their eye off the ball in terms of their long-term investing plans even with everything that's happening in the market. Given where some of the valuations in investor's portfolios have gone, I know a lot of you are probably thinking about rebalancing and making some changes right now.

Something we want to talk about in particular today is commodities. Commodities have obviously been moving around quite a bit. I think we've seen oil go from $60 to $140, back to $60 all in a year's span, and gold has been moving around a lot too.

In general asset allocation, commodities play a very special role. Here to talk to me today about that is analyst Bradley Kay. Thanks for joining me.

Bradley Kay: Glad to be here.

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Scott Burns: Let's talk about commodities. In an asset allocation portfolio, what is the general role commodities play?

Bradley Kay: Commodities are a great diversifier. They are in fact one of the best we know of. They have about a 0% correlation with stocks and bonds historically, which even though they have slightly low returns and slightly higher volatility, still means that they can help out inside a portfolio.

Scott Burns: OK, so when commodities are in a portfolio, what's kind of the target allocation that we recommend for people to have?

Bradley Kay: Well, of course it always depends on an investor's personal situation at the moment, but in general, we tend to recommend somewhere between a 5% to 10% stake, depending on that investor's view of the long-term potential returns.

Scott Burns: So, you've got commodities in your portfolio, and by and large, if we are talking with investors who are using ETFs, there is the iPath Dow Jones-AIG Commodity Index DJP, often called the DJP, it's an ETN. It's the largest ETN in existence, and I would have to say--hazard a guess, 85% of asset allocators using ETFs are using this as their commodity anchor.

But there is another fund out there that we've really taken a keen interest in, and that's the Elements S&P CTI ETN LSC. I would hazard that the L, S and C, it stands for the Long-Short Commodities. So, what's so interesting about this LSC fund?

Bradley Kay: Yes. It's a very intriguing fund, because it's one of the first that really takes advantage of momentum that is known within commodity prices. So, commodity prices in general are driven by two things, either supply constraints or macroeconomic conditions.

Both of those tend to persist over time. If you've got supply constraints, if you don't have enough crops, if you don't have enough mining equipments, then it can generally take about a year to clear up.

If you have macroeconomic conditions, good macroeconomic times generally followed by more good macroeconomic times. Bad macroeconomic times tend to be followed by more bad.

As that tendency causes things like inflation to persists or rising commodity prices to persist over time, and this takes advantage of it by going either long or short in the major sector of commodities, depending on how the price has been moving over the last couple of months.

Scott Burns: So, the fund uses momentum to kind of rebalance itself?

Bradley Kay: Yes, exactly. So, this we've actually found tends to provide still quite a good inflation hedge. So, when commodity prices are rising over time, it still tends to shift into all long positions to give you that inflation hedge.

But at the same time, were periods, let's say like the 1990s, where we almost had deflation, commodities and decrease in price. This index was able to sense that and shift in towards mix: some long, some short, depending on who was facing supply constraints at the time versus where was deflation taking over and we were getting lower prices.

So, it was still able to produce better returns with lower volatility than standard long only commodity indexes.

Scott Burns: So, should investors be concerned that they give up that zero correlation, that was the reason for having commodities in there in the first place?

Bradley Kay: Actually no. We found that they still provide almost exactly the same level of correlation as commodities. They still provide really a 0% correlation in recent years. Actually if you go back to the 1980s, you're looking at almost a slight negative correlation with stocks.

Scott Burns: So, it's kind of a commodity fund with brains basically?

Bradley Kay: It is. So, it seeks to really reduce some of the volatility that is the major drawback of commodities as an asset class, while still providing slightly better returns.

Scott Burns: Well, how has it been doing lately with the commodities zigzagging all over the place?

Bradley Kay: Lately it's been doing very well actually. This is one thing that's given us a lot of faith in the index and its methodology. It's that what we saw was that at the tail end of this commodities boom that's been happening really since about 2002, 2003.

It really started to tail off in about September and August of this year. So, we saw it actually in long positions and virtually every type of commodity. Then, as commodity started to go down in September, we had about a 10% loss in the fund.

Same as with most of their commodity ETFs, but then actually it started to shift into the short positions. During October, we actually saw it rise about 10%, as the other ETFs continued to fall.

Scott Burns: Sounds like something worth checking out. I do think one thing we need to make sure we caution investors on it. It's that it is actually an ETN, and not an ETF. That comes with some pros and some cons. How does the ETN structure affect investment decisions in this?

Bradley Kay: Well, the ETN is actually just a promissory note issued by a bank. So, you are exposing yourself to the credit risk of the underlying bank that backs it, which in this case is HSBC.

Scott Burns: OK. So, HSBC has not been unaffected by the credit crunch, but it's weathered it a lot better than most actually. I think it's the largest bank right now.

Bradley Kay: Yes it is.

Scott Burns: So, you get some benefits from the ETN structure, but there is some drawback there. I mean do you think investors should buy it with that kind of credit risk in mind? I mean how does that affect the decision?

Bradley Kay: Investors should be aware of the credit risk, but thus far, even say Morgan Stanley has issued some ETNs. We have not really seen a major blowup along those lines. We have seen a couple dips in the price below net asset value, but even that was mostly at the very worst times of the credit crisis.

Scott Burns: Alright. Well, Bradley, thanks for taking the time to talk about this fund.

Bradley Kay: Always a pleasure.

Scott Burns: As investors and advisors look to rebound their portfolios, we'd like to just go out there to consider the Elements S&P CTI ETN for part of your commodities exposure. I'd like to think of it as a commodities ETN with brains.

I'm Scott Burns, director of ETF analysis here at Morningstar. For reports on this fund and other ETFs and all your other ETF information, please check out Morningstar.com and the Morningstar ETFInvestor newsletter. Thank you.

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