Commodity Exposure and the Question of Structure

Following the crash of 2008, the broad commodities space went on an upward tear. Since the end of February 2009, the Dow Jones UBS Commodity Index gained nearly 60%. During the same period, investor interest in the space has increased dramatically as assets to (non-equity-based) commodity-focused exchange-traded products increased by nearly 278%.

In a historical context, a broadly based commodities position has been found, within a well-diversified portfolio, to provide the benefits of inflationary hedging and diversification away from the correlation of traditional asset classes. On that basis, we feel very comfortable allowing for a 4% to 10% commodity allocation to the core of one's portfolio. Within the space, even offerings with the same target commodity exposure come in a number of flavors with respect to structure. Which one you should choose hinges on a number of considerations, including your investment thesis, objectives, and risk-profile. Here, we will discuss the mechanical differences between commodity-focused ETP structures and to which ends each can be best utilized.

It's Hard to Spot � "Spot"
Those unfamiliar with commodity exposure generally assume that all funds targeting a particular commodity will deliver its day-to-day price performance, net a management fee. While the assumption is an intuitive one, procuring exposure to the price performance of immediately deliverable commodities, also known as the "spot" or "cash" market, is trickier than one might expect.

There are a number of ETPs that do, in fact, deliver the performance of spot. To do so, these products back their shares with physical holdings of the target commodity. As one can imagine, the logistical obstacles posed by the need for storage space have ensured that physically backed ETPs target commodities with very high value/size ratios. Effectively, these offerings are relegated to the precious-metals space, given their ease of storage.

In many ways, the fact that investors can gain direct exposure to precious metals has proved rather fortuitous. Precious metals, and gold in particular, are likened to monetary specie and looked to as safe-haven assets and reliable stores of wealth in times of panic. Given the recent crash and the inflationary fears spurred by the historically loose monetary policy that ensued, gaining exposure to the precious metals with little to no tracking error is of high priority. While some feel such fears to be overblown, the truth may be in the assets. The physically backed  SPDR Gold Shares (GLD) has grown to become the second-largest exchange-traded product of any kind, with over $56 billion of assets under management, as of this writing. As we will discuss later, ETPs using other methods to provide commodity exposure see varying levels of decoupling from spot-price fluctuations, but physically backed offerings like GLD offer near-perfect tracking.

Investors should understand that funds like GLD are not technically ETFs. They are structured as Grantor Trusts. They don't make distributions, and their look-through tax status requires that they be taxed as collectibles. Currently, collectibles are taxed at ordinary income rates, at maximum of 28%.

Futures-Based
A futures contract obligates the purchase and sale of a set quantity of a commodity at a set date in the future and at a set price. Because the actual transaction will take place in the future, a number of factors outside of current supply and demand will provide pricing pressures. These include things like carry costs required to compensate the seller for effectively holding off on delivery, seasonal use, production trends, and future expectations.

On that basis, futures contracts seldom trade at their commodities' current spot prices. Their price performances are, however, a derivative of the performance of the actual commodity, so futures are generally highly correlated with their target commodities.

To avoid physical delivery while maintaining exposure, ETPs that use futures must sell their near-to-expire contracts and purchase those further from expiration. This is known as rolling a position forward. The prices of contracts at progressively further expiration dates comprise the futures curve. When the curve takes an upward slope--a situation known as contango--rolling a position forward creates a loss. The loss or gain accrued from the roll is called a roll yield. A persistent state of contango can spell trouble for funds whose methodologies require that they consistently roll into contracts facing a steep negative roll yield.

This circumstance proved a major shock to investors in  United States Natural Gas (UNG) back in the summer of '07. Though natural gas spot prices gained about 1%, UNG posted a 12% loss. The spot commodity made gains, but they weren't enough to offset the negative roll yield created by a steep level of contango at the front of the futures curve.

To mitigate the outsized effects of contango, a number of futures-based ETPs have adopted dynamic methodologies. PowerShares, for instance, launched a line of products that utilize the Deutsche Bank DB Optimum Yield methodology to put on contracts, as far out as 13 months, that look to maximize the benefits of a positive roll yield while avoiding the losses associated with a nagging state of contango.

While physically backed exposure would be preferable for satisfying a core holding, it isn't available across the broad commodities space, and so investors are left to turn to futures-based ETPs for exposure. That said, investors should rest easy knowing that the problem of tracking has been tempered to a very large extent by the aforementioned dynamic strategies. For instance, in the past six-month, one-year, and three-year periods, the S&P GSCI Crude Oil Spot index returned 33.45%, 27.41%, and negative 1.66%, respectively.  United States Oil (USO), which tracks only front-month futures, underperformed severely over every time frame, returning 22.25%, 5.06%, and negative 19.36%, respectively. While the dynamic alternative,  PowerShares DB Oil (DBO), also underperformed, it did so to a far smaller degree, returning 27.22%, 14.13%, and negative 4.54% over the same periods, respectively.

Like their physically backed counterparts, these offerings are not technically ETFs. Held in a traditional brokerage account, investors here will be required to pay capital gains taxes each year in which there is a nonrealized gain, regardless of sale. Of these gains, 60% are taxed at long-term rates while the remaining 40% are taxed at short-term rates. Gains of funds that turn to swaps and/or options to procure commodity exposure may not be subject the 60/40 rule. It is important to note that these funds typically do not distribute realized capital gains, so investors may need to pay capital gains taxes out of pocket. Additionally, futures-based ETPs margin their futures positions with cash or cash equivalents, held as collateral. Generally, funds will hold T-bills, and despite how low rates have fallen in recent years, the holding will generate interest that investors must recognize in their tax filings.

Equity-Based
Equity-based ETPs fall into the "traditional" ETF category. These funds aim to provide price performance highly correlated to a particular commodity or group of commodities by holding the equity securities of companies that are highly leveraged to their production servicing or use. These offerings are the most traditional and oldest among commodity-focused offerings. To an extent, these funds blur the line between sector focus and commodity focus. A position in  Energy Select Sector SPDR (XLE), for instance, will deliver upwards of 77% of an investment in  Oil Services HOLDRs . This is important to note, as it is indicative of the fact that tracking to commodity prices here can be very poor relative to a single target commodity as equity- and sector-specific price pressures rear their heads.

A number of equity-based funds do target particular commodities by selecting a highly focused group of companies, but even in these cases, there are extraneous considerations to be had. One should understand the operating leverage that these offerings can provide. In many cases, fixed costs account for the majority of these firms' expenses, so as demand for their target commodities increases, their profitability sees an exaggerated move to the upside. Understand, however, that leverage cuts both ways, and a temporary drop in commodity prices can lead to a nagging underperformance.

For instance, in the past one- and three-year periods, the S&P GSCI Gold Spot index gained 29.20% and 16.04%, respectively. While both the physically backed and the futures-based offerings tracked very well,  Market Vectors Gold Miners ETF  (GDX) gained 36.67% and 8.32%, respectively. While tracking here is likely to be poor relative to physically backed and futures-based alternatives, an equity-based offering may provide the best leverage when looking to make a short-term directional bet on the price performance of a particular commodity. This is so much the case that one might even consider using equities in lieu of a highly specialized 2 times leveraged product. During the past six-month and one-year periods, ProShares Ultra Gold (UGL) gained 17.82% and 57.15%, respectively--roughly twice that of spot. In the same periods  Market Vectors Junior Gold Miners (GDXJ) gained a dramatic 25.07% and 63.73%, respectively.

Another upside to this method of gaining commodity exposure is its simplicity from a tax perspective. Because these offerings are structured as funds, they are taxed as any other equity ETF, so investors need not worry about K-1s and collectibles.

A version of the article ran on March 30, 2011.

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