Investing in Commodity ETFs
Bradley Kay
Associate Director, ETF Research
Ben Johnson
ETF Strategist
May 2010
© 2010, Morningstar, Inc. All rights reserved.
The Case for Commodities
2
3
Total Assets ($ billions)
0
20
40
60
80
100
120
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Commodity Assets Exploding
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
The Fear Factor
This is really two stories: one centuries-old and one brand-
new
The biggest commodity funds across all markets invest
directly in gold (and other precious metals to a lesser extent)
Ancient hedge against monetary inflation
ETFs allowed direct investment without retail mark-up
The broad variety of other ETFs and ETCs invest in
commodity futures
Also partially serve as inflation hedges
Motivated by academic work from Gorton & Rouwenhorst
4
A Diversification Goldmine?
An early working version of Gary Gorton and Geert Rouwenhorst’s
paper “Facts and Fantasies about Commodity Futures” began
circulating the finance community in 2004
Examined returns to commodity futures from 1959 through 2004
Suggested that commodity futures could provide the ultimate
addition to a balanced portfolio
Similar returns and standard deviations to equities
Zero-to-negative correlations with other asset classes
Superior inflation hedge to equities
5
The Ghost of Commodity Futures’ Past
Annualized Excess Returns over Cash
Commodity Stocks Bonds
Futures
Average 5.23 5.65 2.22
Std. Deviation 12.10 14.85 8.47
% Returns > 0 55 57 54
Correlations with Commodity Futures Returns
Stocks Bonds Inflation
Monthly 0.05 -0.14 0.01
Quarterly -0.06 -0.27 0.14
1-Year -0.10 -0.30 0.29
5-Year -0.42 -0.25 0.45
All table data replicated from Gorton & Rouwenhorst (2005), commodity futures returns from
July 1959 through December 2004
6
Where Do These Returns Come
From?
7
The Ghost of Commodity Futures’ Past
Returns mostly came from the futures investment strategy, not from
the commodity prices themselves
source: Gorton & Rouwenhorst (2005)
8
Sources of Commodity Futures Returns
Commodity futures returns can be broken
down into three components
Spot return
Collateral (cash) return
Roll yield
Spot returns drive much of the short-term
variation in commodity futures returns
Roll yields drive much of the long-term returns
of commodity futures returns
9
What Produces Roll Yield?
Commodity futures rarely trade at the same price as spot (the
price to purchase a commodity that day on the open market)
If commodity futures trade for a lower price than spot, we say
that market is in “backwardation”
This means you are being paid to wait for delivery
Serves as insurance for commodity producers locking in sales
Predominant state of commodity futures markets for decades
If commodity futures trade for a higher price than spot, we say
that market is in “contango”
This can destroy returns to a futures investment strategy!
10
What Produces Roll Yield: An Example of
Backwardation
WTI Crude Futures on 31/12/2007
source:
98 Bloomberg
96
94
92
90
88
86
84
3M
6M
8M
1Y
2M
4M
5M
7M
9M
2Y
13M
10M
11M
14M
15M
16M
17M
18M
19M
20M
21M
22M
23M
Spot
Backwardation means futures (roughly) trade at a discount
Buy futures 3 months out at $95.78
Sell at spot price of $96.00
Gain of 0.23% in one quarter Annual benefit of 0.92% from roll yield
11
What Produces Roll Yield: An Example of
Contango
WTI Crude Futures on21/5/2010
source:
80 Bloomberg
78
76
74
72
70
68
66
5M
2M
3M
4M
6M
7M
8M
9M
11M
19M
10M
13M
14M
15M
16M
17M
18M
20M
21M
22M
23M
1Y
2Y
Spot
Contango means futures (roughly) trade at a premium
Buy futures 3 months out at $71.67
Sell at spot price of $68.04
Loss of 5.1% in one quarter Annual drag of 18.8% from roll yield
12
The Devastating Effects of Contango
26K
24K
22K
20K
18K
16K
14K
12K
10K
8K 2006 2007 2008 2009 2010
Investm ent Name Value
DJ UBS C om m o dity Spot P R USD (Ma rk et R eturn, USD, ...18.77K D J U BS C o m m odity TR USD (Ma rk e t R eturn, USD, Pre -T...
10.67K
Commodity futures indices no longer outperform spot prices
Source: Mo rningstar Direct
13
The Devastating Effects of Contango
19K
13K
9K
7K
5K
4K
3K
4/2008 7/2008 10/2008 1/2009 4/2009 7/2009 10/2009 1/2010 4/2010
Investm ent Name Value
He nry Hub Natural Gas Spo t Price (Ma rk e t R eturn, USD...5.54K ETFS Natural Gas ETC (Mark et R e turn, USD, P re -Ta x ) 2.11K
Individual commodities can see especially large roll yield losses
Source: Mo rningstar Direct
14
Looking to the Future
15
Bad News for Traditional Commodity Indices
Contango is still extremely prevalent throughout the benchmark
futures contracts used by most commodity indices
Out of 28 major commodity markets, on May 25, 2010:
22 are in contango
3 have flat prices (Live Cattle, Feeder Cattle, Platinum)
Only 3 are in backwardation (Cotton, Lean Hogs, Crude Palm Oil)
Traditional commodity indices in this environment will continue to
lose money on the roll yield
Most likely remain a useful hedge against inflation
Correlation with stocks likely to remain higher as commodity
prices become more of a “global growth” bet
Overall returns prospects are incredibly poor so long as the
futures markets mostly remain in contango
16
Commodity Futures Markets May Never Be
the Same
Contango may not disappear, but instead become the new
normal state of commodity futures markets
Institutional and now retail investors have flooded a small
market with capital in the search for diversification
This long-only demand for futures has driven up their price
beyond what market makers can reasonably arbitrage away
Until investors move their money out of long-only, fixed-
contract commodity futures indices, their returns will remain
underwhelming
17
Commodity Indices: The Next Generation
Intelligent long-only indices
Within each market: identify the contract with the
least drag from roll yield
Across all commodities: identify the futures markets
with the greatest returns potential
Long-short indices
Transparent, rules-based attempts to replicate a
hedge fund strategy
Allowed to short commodity futures markets with
very poor returns prospects
Maintained a low correlation with other markets in
2008-2009
Could sacrifice the inflation hedging benefit of long-
only indices
18
Intelligent Long-Only Indices Offer Better
Returns
230
220
210
200
190
180
170
160
150
140
130
120
110
100
90
80
70
Au 5
Au 6
Au 7
Au 8
Au 9
N 5
Fe 5
N 8
N 9
N 6
Fe 6
N 7
Fe 7
Fe 8
Fe 9
M 5
M 7
M 8
M 9
M 6
10
0
-0
-0
-0
0
-0
0
0
-0
-0
-0
-0
-0
-0
0
0
g-
g-
g-
g-
g-
b-
b-
b-
b-
b-
b-
ay
ay
ay
ay
ay
ov
ov
ov
ov
ov
Fe
Deutsche Bank Liquid Commodities Index Optimum Yield
Newer commodity indices mitigated the effects
Dow Jones UBS Commodity Index Total Return
of contango through careful contract selection
19
Long-Short Commodity Funds Offer Excellent
Diversification
1 2 3 4 5 6 7 8 9
1 Ba rCap Global Aggre gate TR USD
2 MSC I W orld GR USD 0.46
3 DJ UBS Com m odity Spot 0.39 0.59
4 DJ UBS Com m odity TR USD 0.39 0.59 0.99
5 S&P GSC I TR 0.27 0.59 0.91 0.93
6 DB Liquid Com m odity O ptim um Yie ld... 0.38 0.57 0.94 0.95 0.97
7 Morningstar Long/Short C om m odity TR -0.09 -0.21 0.33 0.32 0.21 0.23
8 S&P C TI TR USD -0.31 -0.46 -0.09 -0.09 -0.11 -0.12 0.63
10
Long-short indices following momentum strategies provided one of the
11
few sources of diversification during the period of 2007-2009
12
13
14
20
15
A Quick Regulatory Overview
US regulators imposed position limits on commodity futures in
January 2010
Extremely high limits, particularly for swap-issuing banks who
manage most commodity funds
In practice, these will have little-to-no effect on commodity funds
New regulation in US Congress might force American banks to spin
off their swaps desks and other derivative operations
Could interrupt commodity funds where American banks act as
the swap counterparties (Source, ETFS to a lesser extent)
Extremely unlikely to cause any loss of capital
Any funds that invest directly in exchange-traded futures rather
than swaps will face little to no consequences from potential
legislation or regulation
European authorities have made no move to crack down on futures
investments or swap markets
21
Investment Outlook
22
Morningstar’s Outlook for Energy Commodity
Prices
Our Energy Team regularly vets its long-term price
assumptions for oil and natural gas
These prices are used in conjunction with near-term futures
prices in their valuations of global energy companies
Current long-term oil and natural gas price assumptions are
arrived at using a scenario-weighted approach
23
Morningstar’s Outlook for Natural Gas Prices
Long-term NYMEX Henry Hub natural gas price
assumption - $7.50/mcf
High case scenario - $15/mcf (20%)
Base case scenario - $7.5/mcf (40%)
Low case scenario - $5/mcf (40%)
Current spot price: $4.10/mcf
Key Considerations
Shale gas
Positive, long-term demand fundamentals
Falling well costs
24
In Summary: Gold & Other Precious Metals
These assets look a bit pricey at the moment
Other hard assets may provide better protection
against monetary inflation
Not necessarily a good time to overweight gold,
despite rising risk of sovereign default and
monetary inflation
Most providers offer physically-backed
No reason to invest via futures-based funds
25
In Summary: Long-Only Commodity Indices
Offer a useful inflation hedge
Only buy broad indices
× Diversification in a very volatile asset class
× UCITS compliant
× Lower cost
× Follow a second-generation strategy such as
Deutche Bank’s optimum yield indices
× Could take up 5-10% of a balanced portfolio in
conjunction with gold & precious metal holdings
26
In Summary: Long-Short Commodity Indices
Not as certain of an inflation hedge
Will likely offer superior diversification and returns
relative to traditional indices over the next five to
ten years
× Could take up 5-10% of a balanced portfolio
× Should be considered in conjunction with other
alternative investment holdings
× Hedge funds (especially Global Macro and CTAs)
× Absolute return funds
27
28
