ETFs: Straight to the Source

Diversification with commodity-based exchange-traded products can reduce portfolio volatility and boost returns.

By Greg Newton

To think of a time when commodities — the basic resources of food, energy and metals on which civilization is built — have garnered as much attention as they have in recent years, it's necessary to go back to the stagflation days of the mid-1970s. But the dramatic run-up in prices, especially for oil, through the first half of 2008, and their even more dramatic collapse as the spreading financial crisis lowered global growth projections, have made commodities one of the biggest and most controversial news stories of the year.

The recent selloff has also made commodities one of the best investment opportunities, especially for those quick enough to get on the right side of the trade at the right time. While commodities, like virtually all other asset classes, have exhibited extraordinary volatility in this historic year for financial markets, the availability of commodity-based exchange-traded funds (ETFs) and exchange-traded notes (ETNs) has made it much easier for individual investors to participate in an underappreciated asset class.

The argument for including commodities in an investment portfolio boils down to a single word: diversification. Academics and commentators can, and do, endlessly debate the source of commodity returns, the correlation of different commodities and many other aspects of commodities' portfolio attributes, including inflation protection; however, their findings are practically unanimous.

Over virtually any time frame, from years to decades, and over any time window, an allocation to commodities will both reduce portfolio volatility and enhance riskadjusted returns compared with a portfolio consisting solely of stocks and bonds. The last few months, when many commodity prices fell further and faster than stock markets, were merely an exception to the established rule that commodity returns don’t correlate with those generated by traditional portfolio constituents.

The once widely accepted case that commodities would "go up forever" because of rising demand from developing countries and declining supplies is obviously being questioned at the moment. But one should remember that the so-called commodities "supercycles," like those of stock and other markets, have historically endured for around 18 years each and sometimes included dramatic corrections along the way.

The argument for including commodities in an investment portfolio boils down to a single word: diversification.

Everything From Crude to Cocoa

The first pure commodity ETF arrived on the U.S. investment scene in late 2004 with the launch of what is now the SPDR Gold Shares (GLD), with each share representing one-tenth of an ounce of the precious metal. On June 30, 2008, it held more than 750 metric tons of gold, ranking it eighth, between Japan and the Netherlands, on the World Gold Council’s list of the world's largest gold holdings.

It has since been joined by more than 80 ETFs and ETNs offering exposure to indexes as broad as the S&P GSCI (formerly the Goldman Sachs Commodity Index) and the Dow Jones-AIG indexes, or as narrow as single commodities, from crude oil to copper and from corn to cocoa.

GLD and its competitors, the iShares Comex Gold (IAU) and Silver (SLV) trusts, are relatively unusual in that their shares are backed by physical metals holdings. The vast majority of commodities ETFs and ETNs invest in futures contracts or baskets of futures contracts, and most aim to replicate the daily performance of those underlying investments. The principal difference between ETFs and ETNs is that the former actually hold the fund's investments; ETNs, by contrast, are senior, but unsecured, debt obligations, usually of an investment bank affiliated with the sponsor, which exposes investors to counterparty credit risk.

Two sponsors dominate the commodity ETF market, even if the total assets in their product families fall far short of GLD's assets. Barclays, under its iPath brand, offers more than 20 broad-, sector- and single-commodity ETNs, mostly based on the widely followed Dow Jones- AIG and S&P GSCI commodities indexes, as well as gold-, silver- and GSCI-based ETFs from its better-known iShares family.

Its largest competitor is Invesco PowerShares, which earlier this year became the first sponsor marketing agent to offer levered and short ETNs to its original Deutsche Bank Commodity Index-based family of a single broad commodity ETF; four sector funds covering agriculture, base metals, energy and precious metals; and single commodity funds for gold, silver and oil. The DB commodity indexes use an "Optimum Yield" strategy designed to participate in the positive aspects, while minimizing the negative impact, of the futures pricing curve on fund performance.

The Elements family joined the fray in 2007. So far, it consists of ten ETNs, including four tied to the return of the Rogers International Commodity Index (originally developed by investor Jim Rogers); five tied to individual Merrill Lynch commodities indexes; and one based on the S&P Commodity Trends indicator, which is unusual in that it applies a long-short strategy to six commodity sectors. The benefit of that approach is clearly evident in the ETN's returns since its launch in June 2008: On Oct. 31 it was up 6.5%, while the Dow Jones-AIG commodity index had lost 42% over the same period.

Other sponsors active in commodities include UBS, which offers eight E-Trac ETNs based on the UBS Bloomberg Constant Maturity commodity index or its subindexes, and US Commodity Funds LLC, which offers the pioneering US Oil (USO) ETF, along with others tracking natural gas, gasoline and heating oil.

Broad, Sector or Narrow?

A look at the PowerShares commodities ETFs clearly shows some of the choices investors often confront when considering a commodities ETF or ETN investment.

Its DB Commodity Index Tracking Fund (DBC) divides its assets among six commodities representing the main commodity sectors: energy, represented by crude oil and heating oil, accounts for 55% of its base weighting; aluminum, representing industrial metals, accounts for 12.5%; corn and wheat, representing agriculture, account for 22.5%; and gold, representing precious metals, accounts for 10%. Despite its relative simplicity compared to the 19-component Dow Jones-AIG commodity index and the 24-component S&P GSCI (which has about 75% of its assets devoted to various energy-related components), the fund offers exposure to six of the most heavily traded and important commodities.

For investors seeking a commodity sector focus, separate PowerShares ETFs are available for agriculture (DBA), which includes soybeans and sugar as well as wheat and corn; base metals (DBB), which includes aluminum, copper and zinc; energy (DBE), which includes both Brent and West Texas Intermediate crude oil, with heating oil, natural gas and gasoline; and precious metals, an 80/20 split between gold and silver.

Rounding out the basic ETF offerings are single commodity funds for gold (DGL), silver (DBS) and crude oil (DBO).

Building on those core products, PowerShares has introduced a range of Deutsche Bank-sponsored ETNs offering short, double-short, long and double-long exposure to the performance of the agriculture and base-metals sector indexes, the crude oil and gold singlecommodity indexes, and the broad commodities index. The short and double-short products are designed to offer, respectively, the inverse and double-inverse returns of the core product, meaning that they should match a 1% gain in their underlying indexes with losses of, respectively, 1% and 2%.

The entire PowerShares DB commodities complex reported total assets of $4.5 billion on Oct. 31, 2008.

Equities Still a Consideration

A range of products is also available for investors who prefer to stay away from pure commodities, but who still want commodities exposure in their portfolios. Market Vectors, the Van Eck Global ETF affiliate, was first to this party with the Gold Miners ETF (GDX), launched in May 2006. The company has since added products covering Agribusiness (MOO), Steel (SLX) and so-called Hard Assets (HAP), the latter based on an index developed in association with investor Jim Rogers. The lineup also includes four energy-related equity-based ETFs covering Global Alternative Energy (GEX), Coal (KOL), Nuclear (NLR) and Solar (KWT).

A range of products is also available for investors who prefer to stay away from pure commodities, but who still want commodities exposure in their portfolios.

PowerShares became the latest competitor in this arena in mid-September, with the release of its Global Agriculture (PAGG), Coal (PKOL), Steel (PSTL) and Gold and Precious Metals (PSAU) portfolios, all based on NASDAQ-OMX indexes designed to measure the overall performance of globally traded securities of the largest and most liquid companies in their relevant industries.

Investors should, however, be aware that equities tend to offer high beta exposure to the underlying commodities. When commodity prices are rising, the related equities tend to rise more quickly; when commodity prices fall, the equities decline more rapidly. While some of this disproportionate movement reflects the impact on corporate profitability of those commodity price movements, another important point is that as equities, they are exposed to wider market movements.

A comparison of the movements in GLD and GDX is illustrative. From inception, GDX ran up 45% to reach a closing high on Mar. 14, 2008. GLD put in its closing high at $99.17 on the next trading day, March 17. Through Oct. 31, GDX declined 62%, while GLD declined just 30%.

While the argument for commodities exposure has unquestionably been undermined by the market reactions of recent months, the wide range of ETFs and ETNs now in the market means that investors have a wide range of choices available for the day when more normal market conditions return.

The Intelligent Approach

PowerShares Founder and President Bruce Bond offers investors a smarter breed of ETFs.

Start talking exchange-traded funds with Bruce Bond, the founder and president of Invesco PowerShares Capital Management LLC, and it’s not long before the word "intelligent" starts getting tossed around. A lot.

Bond founded PowerShares in 2002 after several years at Nuveen Investments, where he was managing director and vice president responsible for its ETFs, closed-end funds and unit investment trusts. His earlier job titles at Nuveen included director of product marketing, managing director of structured investments and national sales manager.

PowerShares introduced its first ETFs in May 2003. In 2006, it was acquired by global asset manager Invesco Ltd., forming Invesco PowerShares Capital Management LLC, and in 2007 it assumed sponsorship of the QQQQs, the NASDAQ-100 trackers still ranked among the world's largest and most heavily traded ETFs. It now also markets the commodity-dominated offerings managed by Deutsche Bank. All in all, the brand covers more than 130 ETFs, with total assets of $31 billion.

"Historically, ETFs have been about offering investors exposure to market beta," says Bond, referring to the return generated by the market or its sectors. “What we’ve been focused on from day one is finding ways to deliver what we like to think of as intelligent beta, or added value. Instead of just giving investors exposure to traditional market cap-weighted indexes, our objective is to find ways that help reduce risk, or offer the potential for greater appreciation."

The Invesco PowerShares "Dynamic Portfolio" ETFs track the proprietary Intellidex indexes, which use 25 different factors — from consensus analyst estimates, to traditional performance measures such as earnings and free cash flow, to technical indicators — to select stocks from the perspective of their investment merit for inclusion in the underlying index.

The firm also manages the FTSE-RAFI ETF series, which is based on the so-called "fundamental" weighting technique developed by Rob Arnott, chairman of Research Affiliates. These indexes weight stocks based on dividends, free cash flow, total sales and book value, again attempting to identify stocks with potentially superior appreciation potential.

"In a traditional index, market cap is the only factor determining the weight of a security in the index," says Bond. "We think that looking at a wider range of factors to determine the actual size of a company is a more intelligent approach to weighting a market index."

And, given the theme here, it’s no surprise that Bond sees ETFs as an intelligent option for investors, especially as the choices have widened to include other asset classes, including fixed income, currencies and commodities.

"There’s really no shortcut around the need for investors to conduct the same sort of evaluation as they do with any product, so they understand what the differences are between competing products, or, for traditional stock investors, companies," Bond says.

ETFs are generally less expensive than mutual funds offering similar market exposures, much more transparent in terms of their holdings and, because they're traded throughout the day, may be considerably more liquid.

But Bond believes ETFs’ most overlooked benefit is tax efficiency. "PowerShares ETFs have never had to make a capital gains distribution, short- or long-term," he says, addressing the bane of mutual fund investors. He quickly adds the usual disclaimer about past performance being no guarantee of future results. The "in-kind" ETF share creation and redemption process, Bond says, "means that we're not raising cash to meet redemptions, and gives us much better control over the distribution-related tax concerns for investors."

Investing in ETFs and ETNs involves risks similar to those with any other exchange-listed investment, including possible losses. Shares are not FDIC insured, may lose value and have no bank guarantee. Before investing in ETFs or ETNs, investors should carefully review available documents, including risk disclosures and other disclaimers included in the products’ prospectuses, and assess their suitability for their own financial circumstances.