Think Broadly for Commodity Diversification

Christine Benz: I'm Christine Benz for Morningstar.com.

With inflation heating up, many investors are looking to commodities as a way to hedge against higher prices in their portfolios. Here to discuss what you need to know before adding commodities to your portfolio is Abraham Bailin. He is an ETF analyst who specializes in commodities.

Abraham, thanks for being here.

Abraham Bailin: Christine, thanks for having me.

Benz: So, let's talk about commodities as a way to hedge against inflation. What do you need to know when you are thinking about this question?

Bailin: Well, inflationary hedging is one of the big key stand-out benefits of a broad commodity exposure, and I say broad commodity exposure, because if you are dealing with one particular commodity, obviously, there is going to be unique drivers, pricing drivers that come into play. But inflationary hedging is definitely one of the benefits and the other is going to be portfolio diversification away from the correlation of traditional asset classes.

Now, we've had a number of identifiable drivers recently. Certainly, there has been much talk about very loose monetary policy and some of the fiscal stimulus that we've seen, and the argument to that end is that, as we print more money in the U.S. and as the same happens on the global level, hard assets denominated in those respective currencies--here in the U.S. the dollar obviously--are going to become more expensive--and while that effect isn't necessarily quantifiable, it's not hard to argue that we've seen quite a bit of it in the commodity space.

Benz: So, a question I have Abraham is, there have been some issues with exchange-traded funds and notes that focus on commodities being imperfect trackers of actual commodity prices.

Let's talk about that. Should that be an impediment to investors when they are thinking about these categories? Should this be a reason to stay away?

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Bailin: So, you know that's a great point. And as I hope that none of our viewers have had the displeasure to actually feel on their own in their own portfolios, several products that track commodities using futures have seen substantial tracking error relative to their underlying commodities.

Benz: So, you're seeing a commodity do one thing and yet your investment is returning another?

Bailin: Right. And there is couple of reasons for that. So, you have to understand that as an investor when you purchase a futures contract, you're not necessarily gaining a perfect proxy to the underlying commodity.

Futures contracts stipulate the purchase and sale of a particular quantity of a commodity at a particular price, and most importantly, at a particular time in the future. So between now or the time of purchase or sale of the entrance of that contract and the time that that contract expires, there is number of pricing pressure that can come into play that don't necessarily impact the spot market or the physical commodity itself. And so, you're going to get the most outsized decouplings generally at the front end of the curve, and so some of the more traditional exchange-traded products like USO and like UNG...

Benz: So, they track a single commodity?

Bailin: ...And the front month ... single commodity tracking vehicle only tracking the front month futures--you have the potential to see sizable tracking error relative to the underlying commodity.

Benz: So, you were mentioning to me that there are few products that do a better way of washing out some of those issues. So, being more broadly diversified across the number of commodities is one way to improve the experience, and then also you were mentioning that some other ETFs and ETNs use strategies that help them mitigate some of those problems?

Bailin: Sure, absolutely. So, the idea is that these products, they don't want to take physical delivery, right?

Benz: Right.

Bailin: They just want to provide their investors with exposure. So as the contracts near expiration, they sell them, and they buy those that are further from expiration. Well, if those that are further out are more expensive, funds can stand to take a loss.

Now, the difference between the contract that you're selling and the contract that you're buying is going to be different at different expiration dates, at different points on the curve, and so you've seen products like PowerShares DB Commodity Tracking Index, ticker DBC, I believe it was launched in 2006, came out and used a curve positioning strategy that allowed it to participate not only in that front month, but really as far out as 13 months on the curve in order to try and avoid some of the losses that can be associated with rolling.

Benz: Okay. So those are some issues with the products themselves that people need to be aware of. In terms of implementation in a portfolio, say I am a long-term investor looking to add commodities as an inflation hedge or maybe for the diversification benefits. Right now, we're looking at commodities, a lot of the funds are up 30%-35% over the past year. How do investors think about getting into this asset class without getting burned?

Bailin: Well, really, on the more tactical side, or rather the mechanics of these funds, we'd say you should target a broadly diversified exposure. Really that's where you're going to see these inflationary hedging benefits and these diversification benefits.

If you're dealing in one specific commodity, you're really kind of walking a fine line between speculation and investing, because there are a number of commodity-specific and unique price pressures that can come into play that weren't necessarily going to be there in a broad holding. So, we target a broad commodity exposure.

That said, a number of the products, like DBC, have came out that have allowed you to have that broad commodity exposure and not be an expert in futures trading and not have to worry about the shape of the curve or the levels of contango or backwardation along the curve.

Benz: Okay. So a follow-up question. For people who are more tactically inclined, is that a good idea? Is it ever a good idea to use a tactical approach within commodities? And what should you be careful of if you're thinking about that?

Bailin: Sure. Well, to the point of the problem of some of these futures-based vehicles, again understand that you're not getting spot, right, unless you're buying a fund that backs its shares with the physical commodity, like GLD or SLV, that hold precious metals.

Benz: They actually hold the stuff.

Bailin: Yes, they actually hold the stuff, so you're getting exposure to the price performance of the enrolling commodity. With futures contracts, you're not necessarily going to.

Now, if you're speculating in the short term, again, very short term, and we wouldn't recommend this, but if you have an investment thesis that warrants it, you can use those front month contracts, and they'll do just fine. Even better, you might take a look at some of the equity-based commodity-focused ETFs, which can benefit on the upside from a high degree of operational leverage within these spaces.

But on the tactical front, you really need to have a very, very refined investment thesis, because you're traveling into the realm of speculation there.

If you want the portfolio benefits, look to the broad exposure.

Benz: Okay. Well, thank you Abraham for sharing your insights. We appreciate you being here.

Bailin: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.