Exchange traded funds can gain exposure to the changing commodities market through futures-backed fund options or indirectly through company stocks of the producers of raw materials, but which is the better choice?
“Commodity prices have outperformed their respective producers, while experiencing a lower price volatility,” Maxwell Gold, Director of Investment Strategy at ETF Securities, said in a note. “Commodities historically are less sensitive to equity factors and may serve as a better source of diversification compared to commodity producers.”
Commodities are a great alternative investment that provide diversification benefits beyond traditional stock and bond portfolio allocations. With the advent of the ETFs, investors are now able to quickly and easily access broad commodities futures or the company stocks of producers. While more recent performances have been lackluster, commodities have offered a positive risk-adjusted return over the past two decades, both in the price of commodity futures and equities of global producers.
Investors may notice that over the past two decades, an equity investment in commodity companies outperformed the underlying commodities on a total return basis by about 400 basis points. However, this outperformance has come with a 42% higher volatility compared to the underlying commodities, along with greater equity correlation.
Investors should also note that broad commodities have significantly outperformed producers on a spot price basis, with underperformance on manifesting when commodity futures rolling into a higher-priced contract at maturity, or otherwise known as contango.
Consequently, investors may consider later-dated futures contract exposure to diminish the negative effects of contango on their investments.
“Selecting commodity contracts further into the future may help provide a positive yield for investors,” Gold said. “Historically, the roll yield for longer-dated commodity indices garnered a higher total return than commodity producers (6.38% vs 6.23%) as well as a lower volatility than producers and standard commodity indices.”
Currently, the recovery in the commodity markets has lagged behind their producers as the rising equity indices and rising profit margins have helped lift producer company stocks. Nevertheless, the commodities market may see improved fundamentals ahead.
“Commodities may see further upside capture as continued supply side destruction in response to multiple years of overproduction and supply gluts may provide a boost for prices,” Gold said. “Additionally, while falling capital expenditure has boosted producer profitability in the short term, without sufficient investment into new supply and technology long term profitability may suffer.”
On Demand Webcast: Why Commodity ETFs Should Be Part of Your Diversified Portfolio
Investors interested in diversifying their portfolios with commodities exposure have a number of ETF options available to them. ETF Securities recently came out with a line of ETFs to outperform the widely observed Bloomberg Commodity Indices without the need to worry about troublesome K-1 forms come tax season, including the actively managed ETFS Bloomberg All Commodity Strategy K-1 Free ETF (NYSEArca: BCI) and ETFS Bloomberg All Commodity Longer Dated Strategy K-1 Free ETF (NYSEArca: BCD).
BCI tries to provide long-term capital appreciation that exceeds the performance of the Bloomberg Commodities Index. It may not invest in all the components of the benchmark but will hold similar interests to those included in the index, along with short-term investment-grade fixed-income securities, money market instruments, certain bank instruments and cash or other cash alternatives. The underlying Bloomberg Commodities Index tracks the price of rolling positions in a basket of commodity futures with a maturity between 1 and 3 months.
BCD tries to provide long-term capital appreciation that exceeds the performance of the Bloomberg All Commodity Index 3 Month Forward Index, which tracks movements in the price of rolling position in a basket of commodity futures with a longer maturity between 4 and 6 months.
For more information on the commodities market, visit our commodity ETFs category.