Interest in Commodity ETFs Remains High Due to Fed

Since 2008, the federal-funds rate has been driven to near-zero in hopes of stimulating economic activity. Facing anemic growth, however, the Fed has been forced to turn to less conventional monetary policy. Ben Bernanke's most recent speech seems to have left market participants with a key take-away--a second round of quantitative easing, or QE2, is likely on its way.

Those unfamiliar with monetary policy should note that the "quantitative easing" process we are referring to is the one in which the central bank credits its own accounts and purchases financial assets, thus injecting additional funds into the system in hopes of stimulating the economy. The expansion of the Fed's balance sheet will effectively increase the nation's money supply, which some fear will result in further debasement of the U.S. dollar. By definition, inflation occurs anytime the number of dollars chasing a fixed pool of assets increases, so quantitative easing is an inherently inflationary measure.

A Golden Hedge for QE2
Commodities exposure has become quite popular recently, largely because of its low correlation to stock and bond portfolios. Thus, this asset class has been shown to offer the benefits of diversification. Expectations of "easing" and a depressed dollar only continue to fuel widespread interest in commodities exposure. Despite low long-term returns, commodities have historically provided an excellent hedge against inflation.

Some have chosen gold exposure to protect their portfolios. Gold has been on a bull run for the better part of the last decade. Recent market uncertainty and fears of inflation have prompted recurring waves of investor interest, given its preference as a store of value. Gold prices broke through their 1980 high in January 2008 and are currently above $1,300. Some note that there is still room to run toward the previous high, as an inflation-adjusted price puts it above $2,000 an ounce.

There are other ways to frame the most recent upward price trends. Given Bernanke's public indication of his willingness both to expand the Fed's balance sheet and to set a formal inflation target, short-run inflationary pressures may be priced into the market before they are realized.

In either case, short-term timing of this one commodity price is notoriously difficult, and some worry that current valuations have gotten a little rich. On that basis, you may want to consider a broader level of commodity exposure.

Broadening Your Commodities Outlook
A number of exchange-traded funds (such as  PowerShares DB Commodity Index Tracking (DBC) and  GreenHaven Continuous Commodity Index ) and exchange-traded notes (such as  iPath Dow Jones-UBS Commodity Index TR ETN (DJP)) provide convenient access to broad-based commodities exposure. These funds will generally track indexes that provide exposure to the broad commodities space through the use of commodities futures contracts. On many levels, market liquidity and the absence of storage requirements make using futures contracts a better way to gain commodities exposure than direct physical ownership. Investors should still endeavor to understand the implications of futures trading because substantial risk is involved, and under some circumstances, performance will not necessary follow the spot markets.

As of July 31, 2010, the three-year total annualized returns for  United States Natural Gas (UNG) were down 43.26%, while over the same period, natural gas spot prices lost only 15.27%. Funds trading futures contracts can produce such disparities because of the peculiarities of some futures markets. As each contract draws near to expiration, funds must "roll" their positions forward. A fund will sell its soon-to-expire position and purchase a contract further from expiration to avoid physical delivery. Depending on its protocols and the "futures curves" of the markets in which it deals, a fund may well accrue losses or gains not directly related to the price movements of the underlying commodities.

A Quick Note on Backwardation and Contango
When the prices of back-month contracts exceed the price of front-month contracts (known as a state of "contango"), a fund stands to lose money each time it rolls its position forward. In contangoed markets, a fund like the aforementioned UNG can suffer ongoing incremental losses, even as commodity prices in the spot market rise. Investor caution is warranted.

There are, however, cases in which front-end futures are more expensive than back-end contracts. This type of market is said to be in a state of "backwardation," and rolling contracts to later expirations under these market conditions can produce a positive roll yield.

The price trend of futures contracts for any particular market is called the "futures curve." An upward-trending curve denotes a contangoed market and vice versa for those in backwardation. While the majority of commodities markets today are in a state of contango, there are still commodities that are exhibiting backwardation, if only on a portion of the futures curve. The cotton market is currently the most heavily backwardated, while corn, soybeans, coffee, and copper have moved from contango to backwardation in the back-end contracts.

Domestic commodities futures exchanges list contract prices online. While investors can monitor the state of each individual commodity market and invest in single-commodity funds accordingly, broad-based dynamic commodity futures ETFs eliminate the need. Broad commodities funds using these dynamic strategies buy contracts that stand to maximize gains in backwardated markets and minimize losses in those that are contangoed.

Hands-Free Commodity Exposure
Dynamic futures-strategy funds seek to provide an outlet for investors who want commodities exposure but don't want to have to worry about margin calls and how the daily dynamics of the futures market are changing.

DBC, for instance, uses Deutsche Bank's "DB" trademarked "Optimum Yield" indexing methodology, putting on contracts in a diversified basket of 14 commodities, with expiration dates as far out as 13 months, that stand to maximize gains or minimize losses posed by the implied roll yield.

 United States Commodity Index (USCI) attempts to achieve higher risk-adjusted returns relative to funds tracking traditional commodity indexes. USCI delivers broad commodities exposure while maximizing backwardation by sector, rather than anchoring itself to specific commodities. A number of commodities fall into each subsector classification. Thus, the index can both satisfy sector representation and maximize month-over-month momentum by shifting in and out of the various commodities in each subsector, while holding contracts whose expirations look to maximize the implied roll yield of backwardated markets.

Funds such as DBC and USCI provide shareholders with broad-based commodities exposure and may serve as inflationary hedges. Their dynamic futures strategies are, however, relatively complex and may take time for the casual investor to understand. Further, monitoring commodities markets takes time and insight that the average investor is not likely to have.

In addition to serving as an inflationary hedge, commodities exposure can be used to moderate the volatility of traditional stock and bond holdings. While expectations of inflationary action by the Fed may fuel short-run demand for commodities as a tactical investment, our research suggests that investors may maintain a diversified commodities weighting of 4%-10% as a core holding. Those seeking commodities exposure might take a closer look at the number of ETF offerings through which they can conveniently do so.

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