The explosive growth of assets in ETFs tracking commodity returns is a testament to investors’ growing appetite for exposure to this hot asset class. Commodities are the raw materials that feed our modern industries: standard fuels such as natural gas and oil, industrial metals like aluminium and tin, agricultural products including the major grains and livestock, and even gold and other precious metals. The commodity category historically exhibited extremely low—and sometimes negative—correlations with traditional asset classes, which made it an attractive risk diversifier in a balanced asset allocation. Since commodities are physical assets, they have also shown positive correlations with inflation, making them a worthy guardian of portfolio purchasing power.
While the historical track record of the commodity category as a diversifier and inflation hedge has led to its widespread adoption as a distinct asset class in the investment community, its newfound popularity has also in part served to create some issues that have stymied its returns. Chief amongst these issues is the prevalence of persistent contango across many major commodity futures markets. This phenomenon, which is at least partly attributable to the massive amount of investment capital that has flooded these markets in recent years, has obliterated what was the chief source of returns to long commodity futures investments for decades—roll yield (for more on this topic please see our article “Be Cautious With Commodities”).
As we have discussed previously, spot commodity prices do not represent an investable return. Physical holdings of precious metals are currently as close as one can come to achieving spot price exposure in the commodity category. Instead, investors buy futures contracts that represent promises to purchase the commodity at some point in the future (typically in one month to a year’s time). The returns of commodity funds investing in futures contracts will be in part affected by spot price movements, but the roll returns from buying futures contracts at relatively low prices and selling them as they get more expensive close to the expiration date have provided the dominant component of these funds’ total returns over time.
We have previously outlined a number of ways in which index designers have sought to manage roll returns, and specifically highlighted “intelligent” strategies like the Optimum Yield version of Deutsche Bank’s Liquid Commodity Index. This index uses a rules-based system which rolls into the futures contracts that maximise positive roll yield when futures markets are backwardated and minimise negative roll yield when they are in contango. This strategy has proven to be superior to its plain-vanilla counterpart, which merely rolls from one futures contract to another, without regard for the shape and slope of the futures curve. However, other commodity investors have sought to evade issues of contango by avoiding the futures markets altogether.
Is Investing in Commodity Producers a Better Bet?
An alternative to investing in funds that invest directly in commodity futures is to invest in the shares of commodity-producing companies. This strategy also provides some exposure to changes in spot commodity prices and expectations for future commodity prices, since those companies will generally see higher revenues and much greater profits if the commodity they produce rises in price. While this strategy eliminates some of the issues that we have highlighted stemming from common long-only commodity futures strategies, it comes with a whole new set of considerations.
Some considerations unique to an investment in the equity of commodity producers include: cost profiles, financial leverage, operational diversification, and hedging policies.
A commodity producer’s position on its industry cost curve can have a tremendous effect on its financial performance, and hence the performance of its shares, as the price of its product changes. Smaller, marginal producers with extremely unfavourable cost profiles will tend to see very volatile movements in their share prices from movements in prices of their relevant commodities. This is because relatively small movements in the prices of the commodities (and thus in the revenues of the company) can have an outsized effect on these firms' earnings prospects. If copper prices inch above $7,000 per tonne, a copper producer whose break-even cash cost is $7,000 per tonne will—holding all else equal—move from persistant losses to persistant profits, and thus see an immense rise in their stock price. Conversely, a more established producer whose cash costs average $5,000 per tonne of production would see only marginal increases in profits from the higher copper price and thus little change in their stock’s value.
Financial leverage is another consideration that can affect the performance of commodity producers’ equity prices. Highly indebted commodity producers (much like high-cost marginal producers) will tend to see more volatility in their share price performance in response to changing fundamentals.
Operational diversification is another factor to consider. There are very few pure-play commodity producers in existence. Most producers will have diverse exposure to a number of different commodities or end markets. Take BHP Billiton, for example. The firm produces a wide variety of commodities ranging from coal to diamonds. An investment in a mega-miner such as BHP thus provides a degree of diversification across commodities and geographies, but still leaves one exposed to firm-specific risk—like the potential for ill-timed, overpriced acquisitions, which were numerous during the most recent run-up in commodity prices.
Hedging policies are also important to take into consideration. Some commodity producers may take future price risk off the table by locking in selling prices today. If they do so, they may be either capping future upside in their earnings power or mitigating potential downside should their product prices subsequently fall below their hedged prices. Hedge books have been particularly relevant in the gold industry of late. Many gold producers were scrambling to unwind hedge books during the recent run-up in gold prices to better expose themselves to rising spot prices. To the extent that they remained committed to sell gold at prices below spot—thanks to unfavourable hedge positions—these producers ultimately limited their earnings potential and their participation in the gold rally.
A Look at Some Real (Hypothetical) Results
So how does all of this translate into actual investor experience? The chart below shows the performance of the Lyxor ETF STOXX 600 Oil and Gas fund and the Lyxor ETF STOXX 600 Basic Resources fund (the two funds with the longest track records following these indices) versus the Dow Jones UBS Commodity Index.
Since late 2006, both Lyxor sector equity ETFs have on aggregate modestly outperformed the Dow Jones UBS Commodity futures index. The STOXX 600 Basic Resources sector fund ended the period 18% higher than the DJ UBS Commodity Index, but was somewhat more volatile. The standard deviation of monthly returns for the Basic Resources fund was 12.3% versus 8.9% for the DJ UBS Commodity Index. The Lyxor ETF STOXX 600 Oil and Gas fund also bettered (barely) the DJ UBS index, performing just over 1% better in aggregate over the period. The Oil and Gas fund was less volatile than the Basic Resources fund, with a standard deviation of monthly returns measuring in at 7.4% for the period.
So what is the verdict on relative returns and volatility? First of all, we need to keep in mind that this is merely an illustration and by no means meant to serve as a comprehensive study of the relative merits of investing in commodity futures versus the equity of commodity producers. That said, our example doesn’t offer compelling evidence to choose one over the other. The returns to both strategies in this case are fairly similar, as are their levels of volatility.
What about the diversification benefits offered by each vehicle? Are any of the strategies a better risk diversifier than the others? The correlation matrix below shows us that each of these vehicles had fairly strong correlations with global equities—as well as with one another—over the January 2007-April 2010 timeframe. The lowest correlations existed between the two equity sector funds and global fixed income markets (represented here by the Barclays Capital Global Aggregate Bond Index). While these correlations are somewhat low, they are by no means the near-zero to negative figures that were demonstrated by broad commodity futures indices over the past few decades that drove the recent wave of investor interest in the asset class. Furthermore, the two equity sector funds have much higher correlations with the global stock market, which could help explain their low correlation with bonds and should be taken into consideration if fitting commodity-producer equities into a portfolio.
The limited body of evidence we have examined here doesn’t lead us to any strong conclusions. The returns and volatility of the equity- and futures-based avenues highlighted are very similar, while diversification benefits do not clearly tilt us toward the futures-based approach.
What are the ETF Options for Equity Exposure?
Currently the STOXX 600 Basic Resources Index and the STOXX 600 Oil and Gas Index (the same ones featured above) are the best investable options that provide investors with broad exposure to the equity of commodity producers. We have included a table of the ETFs currently available that track these two indices below. In coming articles, we will examine each of these indices and the ETFs that track them in greater detail.
