Commodities ETFs: Diversification and Hedging

• By Jonathan Bernstein, ETFzone.com Contributing Editor
• On 11:30 pm EDT, Wednesday September 2, 2009

Commodities are volatile and complicated, but their diversifying properties have long been noted by investors. ETFs are available now that track every major commodity in the spot and derivatives marketplace. But the new popularity of commodities ETFs has also caused problems.

Commodity ETFs are designed to provide direct exposure to precious metals, energy, meats, grains, and foods. Companies which produce them, such as oil firms, are found in industry sector ETFs, so investors should be aware of double exposure. Commodity ETFs treat the objective of exposure in different ways. Most commodity ETFs own short-term futures contracts which they roll over monthly. Others hold materials directly or hold longer-term futures.

It has long been shown that commodities reduce asset correlation. The chart below compares the year-to-date performance of the benchmark Standard and Poor Depositary Receipts (NYSEArca:SPY - News) with two commodities ETFs: United States Oil (NYSEArca:USO - News), which tracks the price of crude, and PowerShares DB Agriculture (NYSEArca:DBA - News), which offers investors exposure to wheat, corn, soybeans, and sugar.

How does this help an equities portfolio? Through diversification. Stocks and bonds tend to have a relatively high correlation of 0.75 or above, whereas commodities tend to be more poorly coordinated with stocks, often with correlations as low as 0.4. Adding commodities to a portfolio in modest amounts lowers its risk beta, a measure of volatility.

Commodities are also a great hedge against inflation and especially against the devaluation of the dollar. If more dollars are printed or if the dollar drops against other currencies, commodities ETFs will almost certainly be repriced higher in dollar terms.

But commodities carry distinct risks. They are as volatile as ever. Energy is typically the most volatile, ranging from 30-50%. Industrial metals are next. They have a volatility of 20-30%. Agricultural products are typically below 20%. Precious metals are the least volatile of the commodity suite. Commodity pricing is sensitive to everything from world export markets and trade rules, to weather, to fear of contracting swine flu. (This recently has helped to send pork bellies to multi-year lows, despite lack of evidence linking eating port to catching the bug).

In addition to the many risks associate with owning commodities, commodities ETFs face unique problems of their own doing. Some commodities ETFs have become so big they are pushing up prices beyond what natural demand would suggest, and some have become easy targets for traders. If a commodities ETF owns large amounts of the short-term futures contract in an attempt to mimic spot pricing, it will be forced to roll them over frequently at predictable intervals (or sell expiring contracts and buy new ones). Traders can easily guess when these sales and purchases are made (or read the prospectus which may dictate trading times) and simply jump in front, making some easy money off ETF investors.

USO is arguably the most notable example of an ETF forced to change trading strategies. It owned front-month futures contracts which it turned over on a published day every month. Because investors found USO so convenient, USO's holdings bloomed to over 20% of the front month futures contracts for West Texas Intermediate. As the fund grew in size, traders were able to front-run the USO roll-over in large volumes. In fact, some traders openly bragged that making money off the fund was like taking candy from a baby. To make matters worse for investors, during an extraordinary contango in the beginning of 2009, where contracts for later months were much more expensive than the front month, USO paid a premium each time it rolled over its position. USO returns as a result fell far behind spot prices.

One of the golden rules of trading is to disguise the timing and size of trades. USO did neither. It now staggers the dates of its purchases and sales, but its position is still public and it still owns only front month contracts that are rolled over each month.

More recently, the U.S. Commodity Futures Trading Commission has begun regulating position size to curb agricultural commodity speculation. New position limits make it tough for fund managers to track the relevant index. This can have serious consequences for investors. Barclays, for example, was forced to temporarily suspended the creation of new shares in its popular iShares S&P GSCI Commodity-Indexed Trust (NYSEArca:GSG - News). Another Barclays product, Dow Jones-AIG Natural Gas Total Return ETN (NYSEArca:GAZ - News), faced a similar fate.

There are some commodities ETFs which do not use exclusively front-month futures, which can help in a situation of contango (though this would be a disadvantage in a market in backwardation). United States 12-month Oil (NYSEArca:USL - News) is one example. The Agriculture ETF DBA mentioned above does not restrict its holdings to the front month, though it has plenty of front month exposure, and is very likely impacted by the new CFTC rules. A few ETNs diversify into various kinds of arrangements, including private deals done off market, where they can obtain large amounts of exposure without moving the market.

Perhaps the ideal arrangement is owning the actual commodity itself, which works with a dense and non-perishable material. The largest commodity ETF of all, streetTRACKS GoldShares (NYSEArca:GLD - News), holds actual metal stored in a vault in London (and audited occasionally). But beware of taxes. GLD is taxed at a collectible rate of 28% (as opposed to a maximum of 22% on most futures contracts).

Commodity ETFs and ETNs are listed below. (Funds with a daily volume of less than 1000 on 09/03/09 excluded):

GENERAL COMMODITY

• iShares GSCI Commodity-Indexed Trust ETF (NYSEArca:GSG - News)
• Dow Jones-AIG Commodity Index Total Return ETN (NYSEArca:DJP - News)
• ELEMENTS Rogers International Commodity Index ETN (NYSEArca:RJI - News)
• Goldman Sachs Commodity Index (GSCI) Total Return Index ETN (NYSEArca:GSP - News)
• GreenHaven Continuous Commodity Index Fund (NYSEArca:GCC - News)
• ELEMENTS S&P Commodity Trends Indicator ETN (NYSEArca:LSC - News)
• PowerShares DB Commodity Index Tracking Fund (NYSEArca:DBC - News)
• PowerShares DB Commodity Long ETN (NYSEArca:DPU - News)

FOCUSED COMMODITY

• PowerShares DB Agriculture Fund (NYSEArca:DBA - News)
• ELEMENTS Rogers International Commodity Agriculture Index ETN (NYSEArca:RJA - News)
• Dow Jones-AIG Livestock Total Return ETN (NYSEArca:COW - News)
• ELEMENTS MLCX Grains Index ETN (NYSEArca:GRU - News)
• iPath Dow Jones-AIG Sugar Total Return Sub-Index ETN (NYSEArca:SGG - News)
• iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN (NYSEArca:BAL - News)
• iPath Dow Jones-AIG Softs Total Return Sub-Index ETN (NYSEArca:JJS - News)
• Dow Jones-AIG Agriculture Total Return ETN (NYSEArca:JJA - News)
• Dow Jones-AIG Grains Total Return ETN (NYSEArac:JJG)
• iPath Dow Jones-AIG Cocoa Total Return Sub-Index ETN (NYSEArca:NIB - News)
• iPath Dow Jones-AIG Coffee Total Return Sub-Index ETN (NYSEArca:JO - News)
• PowerShares DB Agriculture Long ETN (NYSEArca:AGF - News)
• E-TRACS CMCI Food ETN (NYSEArca:FUD - News)

METALS

• streetTRACKS Gold Shares ETF (NYSEArca:GLD - News)
• iShares COMEX Gold Trust ETF (NYSEArca:IAU - News)
• iShares Silver Trust ETF (NYSEArca:SLV - News)
• Dow Jones-AIG Industrial Metals Total Return ETN (NYSEArca:JJM - News)
• Dow Jones-AIG Nickel Total Return ETN (NYSEArca:JJN - News)
• ELEMENTS Rogers International Commodity Metals Index ETN (NYSEArca:RJZ - News)
• Dow Jones-AIG Copper Total Return ETN (NYSEArca:JJC - News)
• iPath Dow Jones-AIG Aluminum Total Return Sub-Index ETN (NYSEArca:JJU - News)
• iPath Dow Jones-AIG Platinum Total Return Sub-Index ETN (NYSEArca:PGM - News)
• iPath Dow Jones-AIG Lead Total Return Sub-Index ETN (NYSEArca:LD - News)
• PowerShares DB Base Metals Fund (NYSEArca:DBB - News)
• PowerShares DB Base Metals Long ETN (NYSEArca:BDG - News)
• PowerShares DB Precious Metals Fund (NYSEArca:DBP - News)
• PowerShares DB Silver Fund (NYSEArca:DBS - News)
• PowerShares DB Gold Fund (NYSEArca:DGL - News)
• E-TRACS CMCI Long Platinum ETN (NYSEArca:PTM - News)
• E-TRACS CMCI Silver ETN (NYSEArca:USV - News)

ENERGY

• United States Oil Fund (NYSEArca:USO - News)
• United States 12 Month Oil Fund (NYSEArca:USL - News)
• United States Gasoline Fund (NYSEArca:UGA - News)
• United States Heating Oil Fund (NYSEArca:UHN - News)
• United States Natural Gas Fund (NYSE:UNG - News)
• Dow Jones-AIG Natural Gas Total Return ETN (NYSEArca:GAZ - News)
• E-TRACS CMCI Energy ETN (NYSEArca:UBN - News)
• ELEMENTS Rogers International Commodity Energy Index ETN (NYSEArca:RJN - News)
• Goldman Sachs Crude Oil Total Return ETN (NYSEArca:OIL - News)
• PowerShares Deutsche Bank Energy Fund (NYSEArca:DBE - News)
• PowerShares DB Crude Oil Long ETN (NYSEArca:OLO - News)
• PowerShares DB Oil Fund (NYSEArca:DBO - News)

SHORT/LEVERAGE

• ProShares Ultra DJ-AIG Crude Oil ETF (NYSEArca:UCO - News)
• ProShares Ultra Gold ETF (NYSEArca:UGL - News)
• ProShares Ultra Silver ETF (NYSEArca:AGQ - News)
• ProShares UltraShort DJ-AIG Crude Oil ETF (SCO)
• PowerShares DB Crude Oil Double Long ETN (NYSEArca:DXO - News)
• PowerShares DB Crude Oil Double Short ETN (NYSEArca:DTO - News)
• PowerShares DB Agriculture Double Long ETN (NYSEArca:DAG - News)
• PowerShares DB Agriculture Double Short ETN (NYSEArca:AGA - News)
• PowerShares DB Base Metals Double Long ETN (NYSEArca:BDD - News)
• PowerShares DB Base Metals Double Short ETN (NYSEArca:BOM - News)
• PowerShares DB Base Metals Short ETN (NYSEArca:BOS - News)
• PowerShares DB Crude Oil Short ETN (NYSEArca:SZO - News)
• PowerShares DB Commodity Double Long ETN (NYSEArca:DYY - News)
• ProShares Ultra DJ-AIG Commodity ETF (NYSEArca:UCD - News)
• ProShares UltraShort DJ-AIG Commodity ETF (NYSEArca:CMD - News)
• PowerShares DB Gold Double Long ETN (NYSEArca:DGP - News)
• PowerShares DB Gold Double Short ETN (NYSEArca:DZZ - News)
• PowerShares DB Gold Short ETN (NYSEArca:DGZ - News)

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.

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