Commodity ETFs: Still Lowering Portfolio Volatility?

Jonathan Bernstein, Contributing Editor
July 4, 2010

Commodity ETFs have historically provided diversity and reduced portfolio volatility. Lately, exposure to commodities seems to be adding to portfolio volatility rather than reducing it. Do commodity ETFs still provide portfolio diversification and protection for investors?Commodity ETFs have holdings in actual physical commodities or in futures contracts that track the price of these commodities-- a bushel of wheat, for example, or a barrel of oil. Most of the time stocks are relatively high correlated with bonds, with correlations of 0.75 or above. Stocks tend to be more poorly coordinated with commodities, often with correlations as low as 0.4. Adding commodities to a portfolio in modest amounts has historically lowered a portfolios risk beta, a measure of volatility.The chart below shows the 3-year performance of three key commodity ETFs in comparison with the equity benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY - News). ChartCommodity ETFs rode the China growth story high in 2007. They fell sharply during the financial debacle of 2008. Since then they have been remarkably flatwith one exception, gold. The chart above shows this. It compares the price action of an oil fund, United States Oil (NYSEArca:USO - News), a Gold fund, SPDR GoldShares (NYSEArca:GLD - News), and a diversified commodities fund, the PowerShares Deutsche Bank Commodity Index (NYSEArca:DBC - News). About 50% of DBC is devoted to energy (crude, heating oil, gasoline, natural gas, etc.) 25% devoted to metals (gold, copper, aluminum) and 25% devoted to agricultural commodities such as corn, wheat and soybeans.What accounts for this chart? Commodities are especially sensitive to the dollar. From Summer 2007 to Summer 2008 the dollar weakened. The commodities market is global, so as the dollar falls in relation to other currencies, commodities are repriced higher in dollar terms. Through mid-2008, commodities ETFs offered a refuge against a falling dollar and an inflation hedge. As the equity benchmark SPY slipped, all three commodity funds outperformed. Oil fund USO moved up a stunning 100% during that period and the diversified commodity fund DBC not far behind.But beginning in the Summer of 2008, commodity ETFs stopped moving in an inverse relation to stocks. They began moving in the same direction: down. When the economy began cracking, a liquidity crisis forced investors to flee speculative investments. Investors bought treasuries. For the first time in a decade the dollar strengthened dramatically. With the dollar strengthening and inflation turning into deflation, investors no longer needed a dollar hedge. Commodities fell precipitously.As the chart shows, the largest decline was in the oil ETF USO. The rise and fall of USO was exacerbated by the funds methodology for investing in oil. USO holds futures contracts on crude that are rolled over every month. During the run-up in 2007, USO had the benefit of a crude market in backwardation, which means that when the contracts rolled over each month, USO made money on the roll. In July 2008 the market moved to contango and USO paid each month to roll over its position. USO is not unique. Most commodity ETFs invest in futures contracts rather than in the commodity itself. This has benefits for investors, who avoid storage fees and enjoy lower taxes. But in the case of USO in 2008, these considerations were outweighed by a market in fierce contango.Notable in the chart above is that precious metals, and specifically here GLD, did not fall along with the rest of the market. GLD has continued to exhibit countervailing trend characteristics. GLD holds actual gold bars rather than futures contracts. The rollover of futures contracts therefore does not materially impact the price of GLD. But there is a bigger and partly paradoxical reason for the buoyancy of gold. Gold has maintained its value not because industry needed it but rather because it did not. Other commodities, including precious metals such as platinum, have proven more cyclical because of their industrial uses. (Platinum is used as a catalyst for example, so automobile production will impact the demand for platinum). A contracting economy means contracting demand.The outcome of the current debate about whether the withdrawl of stimulus or the increase of government debt is "least worst" medicine for the economy is critical for commodities. Although commodity pricing is still vulnerable to a weaker dollar, commodity prices have stabilized. Meanwhile, interest rates remain at all-time lows. A well-rounded commodity fund like DBC can be expected to perform well as investor confidence returns, with any sign of inflation, or even with an expansion of the money supply. The price of commodities is demand dependent. Industrial demand for metals is often lower in the early phases of recession. But demand for agricultural goods and to a lesser extend energy is stable even during recession. A broad commodity ETF like DBC continues to provide diversity to a portfolio anchored in equity holdings.Commodity ETFs and ETNs are listed below:GENERAL COMMODITYiShares 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 COMMODITYPowerShares 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)METALSstreetTRACKS 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)ENERGYUnited 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/LEVERAGEProShares 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 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.