Friday, 16 November 2012

Best Pick Commodity ETFs/ETNs for the Canadian Long Term Investor

Our original post in 2009 on investing in commodities outlined the diversification and inflation protection arguments as well as the risks. Our next post on the subject in 2010 looked at the then existing ETFs and ETNs to pick out a favorite. It's time to have a look again as several other new funds have come on the scene and the performance track record is accumulating.

The Commodity ETFs and ETNs
The panoply of commodity exchange-traded products available in US markets, which are of course purchasable by the Canadian online investor through a discount broker, is found on both ETFdb and IndexUniverse. We restrict our search to broad funds that track a basket with multiple commodities. There are also many single commodity funds available that are better suited to short-term speculation on the price of oil or gold, for example but we are looking at the investment to go within a diversified portfolio with wide asset classes. The only Canadian offering for a broad product that includes multiple commodities is the iShares Broad Commodity Index Fund (CAD-Hedged) (TSX: CBR).

Here is how we narrowed down the sixteen or so funds from ETFdb's list to the four, along with CBR, that look to be reasonable picks.

1) Futures contract rolling method - We eliminated any funds that use the so-called front month rolling method, which replaces an expiring contract with the nearest-dated contract. As explained in the Ten Commandments of Commodity Investing on Commodity HQ, not using front month rolling is extremely important to minimize the negative return effects of contango. The fund provider iPath emphasizes this primary selection factor in its factsheet iPath Commodity ETNs, in which it suggests that a front month rolling fund such as iPath® Dow Jones-UBS Commodity Index Total ReturnService Mark ETN (NYSE: DJP) is more appropriate to short-term trading. Note that DJP is the second largest fund by assets in the ETFdb list, illustrating that large and popular does not necessarily mean it is appropriate for a specific investing purpose and in our case it is not, so we have excluded it.

Beyond avoiding front-month rolling, it is more or less impossible to tell whose fancy rolling method will turn out to be best. UCI may, however, have slight edge since it buys futures up to three years out, which conforms to the ideas we uncovered in our 2010 post about the advantages of rolling contracts further ahead and less frequently. The usual caution applies - the future may not be like the past that created the data out of which the rolling method was conceived.

2) Index sector balance - We eliminated any funds  where one sector, energy being the problematic one, makes up more than 50% of the weight of the fund. Otherwise the fund's performance is dominated by that one sector. A prime purpose of owning a commodity fund is the diversification effect from the price evolution of various commodities. Our selections all exhibit a balance across multiple commodities. Again, that caused some high profile funds, including the largest of all, the PowerShares DB Commodity Index Tracking Fund (NYSE: DBC), to drop from our list.

3) Management Expense Ratio - Costs always matter, so the lower the MER the better. One of our picks, the UBS Bloomberg Constant Maturity Commodity Index Total Return ETN (NYSE: UCI), has the tied lowest MER of any commodity fund at 0.65%. MER is a big part of the reason our 2010 pick GreenHaven Continuous Commodity Index Fund ETF (NYSE: GCC) has dropped out of the preferred picks list. GGC's MER is 1.09%.

4) Credit Backing - Many of the newer funds are Exchange Traded Notes (ETNs) which rely on the credit-worthiness of the backing institution for capital protection (as opposed to the ETFs which rely on on the value of the portfolio holdings). All of the issuers are investment grade but UBS AG, backers of UCI and UBS DJ-UBS Commodity Index 2-4-6 Blended Futures ETN (NYSE: BLND), is getting towards the lower end of the scale with a Standard and Poors rating of only A. That is in contrast to the rock solid ELEMENTS Rogers International Commodity Index ETN (NYSE: RJI) whose Swedish Export Corporation backer's AA+ rating is higher than that of many governments!

Picks of the litter
Our preferred choices are as follows. Their key characteristics are shown in the detailed comparison table below.

Taxes for Canadian Investors
Taxes are not a differentiator for Canadians. Though US investors may be liable to pay annual income taxes to the IRS for ETFs, but not ETNs, it does not appear to be the case for non-US shareholders (note however, that this blogger is not a US tax accountant so it may be helpful to consult a tax professional). Since none of the funds, ETFs or ETNs, makes or intends to make any annual cash distributions, the only tax liability for a Canadian investor, and this would only apply within a non-registered account (i.e. not RRSPs, TFSAs, RESPs etc), would be capital gains to the Canada Revenue Agency upon sale of the fund.

All these ETFs and ETNs are considered to be US property and subject to US Estate tax provisions, which can apply to Canadians with US investments. See this TaxTips article on the subject but consult a professional to be certain if it applies to you.

Currency Hedging
Is CBR's hedging of the the US dollar worth it? We believe it is likely unnecessary and may detract from diversification but readers may wish to review pros and cons in our previous post on whether or not to hedge currency exposure and some historical results of hedging.

Performance, Correlation and Diversification Experience
How have the commodity funds fared? Have they delivered returns un-correlated  (and thus the diversification benefit) with mainstream equities like the US S&P 500 Index or the Canadian TSX Composite?

As our table shows for BCM, the recent correlation with the S&P 500 is much higher at 0.68 than the 0.3 (see Our Pick for a Broad Commodity Index Exchange-Traded Product) or less found in longer term calculations back to 1990. Several other commodity ETFs have correlations for the most recent 2-5 years in the 0.6 to 0.7 range. Such higher numbers are much less beneficial for diversification. If we eyeball the price movements of some of our funds against the TSX and the US' Dow Jones Index, we get the same impression, that they have been moving roughly in sync, though the commodity funds have more exaggerated ups and downs. The Beta numbers around 1.2 in the comparison table confirm the greater volatility (beta is a measure of stock price volatility relative to the overall market, with 1.0 the same as the market average and above 1.0 more volatile, below 1.0 less volatile).

1) vs TSX Composite (from TMX Money)

2) vs US Dow Jones Index (from Yahoo Finance)

The key question, to which no one really has an answer, will it last or will correlation go back down? Also, will prices of commodities continue their trend of upward price movement begun around the year 2000? The chart below from the latest BMO Capital Markets The Goods newsletter on commodities shows a considerable real return since 200 but flat for a couple of decades through the 1980s and 90s.

The basic decision of whether to invest in commodities may still be open to some question but we feel our above choices of funds will better suit the long term investor.
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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