Tuesday, 16 November 2010

Commodity ETFs - Ins and Outs for Canadians

In our post last year Commodities: Diversifier and Inflation Hedge or Empty Promise? we suggested that ETFs are a good way to invest in commodities. However, controversy has erupted in the mainstream financial press, with articles such as Business Week's Amber Waves of Pain and GlobeInvestor's How to play commodities and not get trampled touting the poor returns of some commodity ETFs, claiming this is due to a charmingly named condition called contango (in which the spot price of a commodity is lower than the upward rising shape, as time to maturity increases, of the futures price curve). Is this a true problem and does that mean an investor should give up on the idea of commodity ETFs? Let's have a look.

Contango is NOT the Dance of Decline
Perhaps contango, not to be confused with the tango, sounds like it should be a dance but it isn't, and so should it not be assumed that it will cause investment losses. The notion that contango inevitably entails return losses gets a debunking from commodities trader George Rahal in Contango, Backwardation and Commodity Index Returns, published in April this year. He finds that, amongst the 15 commodities he tested, gold and silver have been in contango every single year from 2000 to 2009 yet have managed very healthy returns. Testing the opposite condition of backwardation, where futures prices are lower than the spot price, he finds it is not a sure-fire way to profits. He concludes that "there appears to be no clear relationship between “contango and losses” and “backwardation and profits”", which he remarks is consistent with market efficiency. Instead he says the problems lie with index construction which specifies too-frequent and too-near the present month rolling (selling a contract about to expire for one further in the future). Author Rahal explains further his findings in an interview on HardAssetsInvestor.com.

Index Construction is Key to a Commodity ETF's Success
Here is what he suggests looking for in an ETF's index for use by a passive long-term investor as an asset allocation in a portfolio (i.e. not using commodities for speculation or to beat the market):
  • infrequent rolling of futures contracts, ideally once per year
  • rolling contracts further into the future, especially not the nearest month ahead
  • a stable index with minimal changes to commodities and to their weight
In addition, an index should have broad exposure to multiple different commodities to dampen the volatility of individual commodities and to achieve diversification.

How do the Main ETFs Compare?
In the table below, we compare the five largest commodity ETFs available through US exchanges and the single Canadian entrant. Only broad multi-commodity ETFs are included (see ETFdb's list of the whole category) though there are many single commodity ETFs as well. The following table shows the details of key characteristics of the main ETFs. We will focus on the index construction aspects and one matter of concern especially to Canadian investors and note below other factors assessed in two other reviews.

Roll Method
DJP and GSG both suffer from frequent rolling to near-term contracts, while DBC and CBR attempt to combat the assumed problem of negative roll yield through active techniques. RJI and GCC follow a more desirable policy of rolling to longer-dated contracts.

Diversification and the Make-up of Canadian Equity
Within an asset allocation, a Canadian investor is likely to have a big holding in a Canadian equities ETF, such as the iShares Capped Composite Index Fund (XIC), which already has a substantial 26% in energy and 23% in materials (i.e. metals and minerals). A Canadian should not want to load up on more assets in those sectors. GCC fits the bill best in that regard with by far the lowest amount in the energy sector - only 18% - though DJP at 27% is much lower than the others in 40-70% range. CBR seems to have a low allocation but we cannot be sure since the entire sector allocation is not disclosed by Claymore.

The other aspect of diversification is simply the number of commodities and the resultant concentration in any single one. RJI wins that contest hands-down with 37 commodities in its index, including the intriguing Azuki beans and greasy wool.

Other Factors - MER Costs, Bid-Ask Spreads, Risks, Downside Volatility, Past Returns
Barchart has an excellent review of the US-traded ETFs in Our Pick for a Broad Commodity Index Exchange-Traded Product and ends up rating GCC the best pick and DBC in second. Making Sense of Commodity Products at Hard Assets Investor rates DBC highest and GSG second.

Best Overall
GCC takes our winner's laurels due to the particular sector mix of importance to a Canadian and its roll method but one should be aware of its much higher past volatility and downside variance. DBC will be attractive to those who like its low past volatility and downside variance and who believe that its active roll method has merit.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


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Commodity Market