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Investors Should Be Diversifying with Commodity ETFs

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·4 min read
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This article was originally published on ETFTrends.com.

We can no longer ignore the commodities asset class in the current environment, so investors should carefully consider relevant commodity strategies to access this crucial area of the market.

In the upcoming webcast, Inflation, War, and Supply Chain Shock: Navigating Commodities Markets, David Mazza, managing director and head of product at Direxion, noted that commodities have been an outperforming asset class in 2022, outpacing global equities, global bonds, and the cryptocurrency markets.

"Commodities as an asset class have been one of the only bright spots in 2022 during an otherwise difficult market environment," Mazza said.

Mazza also pointed out that economists continue to underestimate inflation as numbers come in above their estimates. The Citi Inflation Surprise Index for the globe shows upside surprises to inflation are off the charts, meaning economist forecasts are way off target. At the same time, forecasts for economic growth are surprising to the downside, meaning growth is not as strong as projected.

Tim Pickering, founder, president, and CIO at Auspice, argued that multiple drivers are setting up a long-term commodity supercycle that could potentially rival and outlast the previous 40+ year commodity supercycle.

"The two basic ingredients required for a commodity supercycle are an extended period of underinvestment in supply, and a generational demand shock," Pickering said. "Today we have both."

In addition, Ed Egilinsky, head of alternatives at Direxion, advised that investors should be looking at alternative assets to diversify a traditional portfolio mix, especially in the current market. For instance, fixed-income assets, which have acted as a conservative portfolio ballast in face of uncertainty, are also at risk in an elevated inflationary environment. He noted that from 1965 through 2021, Treasury bond yield and the inflation rate have moved in the same direction about 80% of the time bond prices and yields have an inverse relationship, so rising yields correspond with falling prices.

Pickering believed that commodities may provide a uniquely valuable diversifying component to any long-term investment portfolio. Commodities can act as an inflation hedge, portfolio diversifier, a potential source of alpha generation, and access exposure to the ongoing green transition.

Specifically, commodities represent a significant portion of the CPI’s volatility, resulting in a positive, and often outsized response to inflation. The asset has a low correlation to equity and fixed income, which can lead to enhanced risk-adjusted returns. Commodity markets offer unique active trading opportunities for capable investment managers to generate alpha. Additionally, looking ahead, we could witness a commodity demand shock due to post-COVID “build back better” infrastructure spending in both developed and emerging markets.

To help put the consequences of rising inflation in perspective, Mazza highlighted the ongoing price increases at the grocery stores. Most consumers have noticed the increase in beef and pork prices, which aligns with the actual increase of pork and beef products.

The FAO Food Price Index, which takes a measure of the monthly change in international prices of a basket of food commodities, rose in March 2022 to an all-time high of 159.7.

As a way to help access these everyday commodities that consumers purchase, investors can look at the recently launched Direxion Breakfast Commodities Strategy ETF (BRKY), a first-of-its-kind ETF offering exposure to the commodities that are commonly included in breakfast. BRKY tracks the S&P GSCI Dynamic Roll Breakfast (OJ 5% Capped) Index, which includes a basket of six commodities, including corn, coffee, lean hogs (bacon), orange juice concentrate, sugar, and wheat, according to a statement from the firm.

The new fund provides access to commodities whose prices are increasing due to supply chain pressures, geopolitical tensions, and weather-related issues. In a period of persistent inflation, this basket of commodities may offer strong diversification characteristics, due to their non-correlated returns in comparison to stocks and bonds.

Additionally, the actively managed Direxion Auspice Broad Commodity Strategy ETF (COM) can help provide a total return that exceeds that of the Auspice Broad Commodity Index over a complete market cycle.

COM will maintain a portfolio similar to those included in the index through exchange traded commodity futures contracts, swap contracts, and investments in other investment companies or exchange traded notes to obtain exposure to the commodities market.

The underlying Auspice Broad Commodity Index is a rules-based index that utilizes a quantitative methodology to track a diversified portfolio of 12 commodity futures contracts dependent on the historical volatility of that component. The total index value is independent of the volatility and position of other components. Each holding is then positioned either long or flat, depending on prevailing price trends.

Moreover, the benchmark includes a “smart” contract roll to minimize the adverse effects of contagion and maximize the positive impacts of backwardation in the futures market. Expiring futures contracts are replaced based on an optimization process that selects a contract from a universe of futures contracts within the next 13-month period.

"We combine systematic long/flat positioning, dynamic risk management, and contract roll optimization in an effort to selectively participate in commodity gains while minimizing volatility and drawdowns," Pickering said.

As a result, the portfolio is "upside opportunistic while limiting downside based on observed momentum and trend within individual commodities," Pickering added.

Financial advisors who are interested in learning more about the commodities market can watch the webcast here on demand.

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