Kicking the Wheel

Traditionally, commodities were a difficult asset class for individual investors to access.  For most people, it just wasn’t practical to trade futures or to take physical delivery of oil barrels.  As a result, the primary investors were the very wealthy, institutions, and companies that had commercial needs for the commodities.  This shut out the average investor from a market that could provide strong returns and low correlations with other asset classes.

Fortunately, financial innovation has created an increasing number of ways for individuals to access commodity markets.  For example, the development of commodity-based exchange traded products (ETPs) has created a simple and inexpensive way for investors of all sizes to gain commodity exposure.  As a result, ETPs in this space have experienced explosive growth.  While these ETPs may seem like a simple solution, they are actually more complicated than many investors realize.  We published a white paper in June 2011 with details on this topic.  You can request the paper at BCM’s website here.   In this post, we’ll take a quick look at a couple of issues relevant to commodity-based ETPs.

First, consider that an increasing number of commodity-based ETPs come in the form of exchange-traded notes (ETNs).  Many investors (including professionals) incorrectly assume that ETNs are the same as exchange-traded funds (ETFs).  While the two share similarities, there are also important differences.  Unlike ETFs, ETNs are typically unsecured debt obligations backed by the entities that issue the notes. In other words, investors that purchase ETNs are exposed to the credit risk of the issuers.  This doesn’t mean that ETNs are bad, it just means that they carry an additional element of risk that must be considered.  Many investors are either unaware of this risk, or worse, simply disregard it.  Those investors should recall that when Lehman Brothers unexpectedly went bankrupt, the ETNs they backed saw precipitous declines in value that went beyond the drawdown of the underlying assets.

Another consideration that many investors overlook is that all commodity based ETPs, whether ETFs or ETNs, typically track the prices of futures contracts, not spot (current) prices.  One common technique is to roll front-month futures, or in other words, to continually maintain exposure to one month ahead contracts.  The reasoning is that near-term contracts should be a good estimate of spot prices.  However, the problem is futures markets often exhibit contango, a condition where futures prices are higher than spot prices.  In contango, ETPs that buy ahead and sell near are basically buying high and selling low.  This results in negative roll yield where the ETP takes a hit with each roll.  This condition can be exacerbated by traders who take advantage of the predictable rolling (i.e. front-running contracts and selling them into ETP rolls).

ETP issuers have developed different techniques to address this problem including going further out on the price curve and even more active contract selection methodologies.  However, these techniques have their own issues and are by no means perfect.  The point is that commodity-based ETPs can be ineffective at tracking commodity prices and may not provide investors with the exposure they expect.  As commodity based ETPs continue to gain popularity, many investors may feel a sense of urgency to participate.  As a result, they may be jumping on a complicated bandwagon without first kicking the proverbial tires (or I suppose “wheels” in this case).  As always, investors should do their due diligence and/or consult with qualified professional advisers before making any investment decisions.  If you have questions or need assistance, feel free to contact BCM.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog constitutes investment, tax, or legal advice. You should conduct proper due diligence and / or consult with professional advisers before taking any investment action.

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