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How to play with pros in the commodities sandbox

Easily bought ETFs and ETNs offer retail investors the ability to make the same bets as more sophisticated investors

By: SIMON AVERY

Date: March 4, 2015

As the Crimean crisis raged last summer, Tyler Mordy and his colleagues at Hahn Investment Stewards made a tactical call in the commodities market. Believing that Russia’s aggression would stoke a major political crisis, they invested in palladium, a silvery-white metal essential in the production of catalytic converters, fuel cells and countless types of electronics.

Russia is the largest source of palladium, and investors speculated about supply disruptions and dwindling stockpiles, sending prices skyward.

“Palladium took off like a scalded cat. It worked out incredibly well for us last year,” recalls Mr. Mordy, who is director of research and co-chief investment officer at the Toronto-based firm.

Playing in the commodities markets used to require buying futures contracts, something reserved for the most sophisticated investors. But over the past eight years, a variety of exchange-traded funds and exchange-traded notes have emerged that manage the actual purchasing and rolling over of futures contracts.

These products can be bought as easily as equities in an online trading account, and they give retail investors the ability to make some of the same bets as the professionals.

To capitalize on the palladium market, Hahn Investments – which relies exclusively on exchange-traded funds to manage clients’ money – bought an ETF listed on the NYSE Arca exchange, called ETFS Physical Palladium Shares (ticker: PALL).

The fund, which launched in January of 2010, is part of a proliferation of new ETF and ETN products that have made it much simpler for money managers and individual investors to buy direct exposure to commodities, without first acquiring a PhD in finance.

That means if you buy into the thesis that nickel prices will rise over the next two years because of the export ban imposed by Indonesia (which mines about one-third of the world’s nickel), then you can make a tactical play with a product such as Barclays Bank’s iPath Bloomberg Nickel Subindex Total Return ETN. It trades on the NYSE Arca exchange under the ticker JJN.

Some of these investment products track shares of companies in a particular commodity business, such as BlackRock’s iShares Global Agriculture ETF, which trades on the TSX under the symbol COW and whose top holdings include Monsanto Co., Archer-Daniels-Midland Co. and Potash Corp. of Saskatchewan Inc. Others hold futures contracts for the commodities themselves, such as Barclays’ iPath Bloomberg Agriculture Subindex Total Return ETN, which trades on the NYSE Arca exchange under the symbol JJA.

Although ETFs and ETNs have made it much simpler to gain exposure to commodities markets, the risks associated with owning commodities remains. Both of these types of investment products hold futures contracts, and as a contract nears delivery date the futures price must converge with the spot market price, producing what’s known as roll yield.

If the price of a futures contract is below the expected future spot price, the situation is called backwardation, which creates positive roll yield. If the price of a futures contract is above the expected future spot price, traders describe the situation as contango. Contango causes negative roll yield. Backwardation generally favours investors in futures contracts, while contango hurts them.

It is also important that investors distinguish between ETFs and ETNs, as they carry different risks. Commodity ETNs are a type of debt where the issuer guarantees results that are linked to the performance of a specified commodity index. Since the payoff depends upon the issuer’s solvency, an ETN’s value can drop if the issuer’s credit rating is cut. ETNs can be held to maturity or bought and sold in the secondary market. In contrast, ETFs are securities that operate something like a mutual fund, but are traded like stocks on an exchange.

“I have never believed that commodities are an asset class per se,” says Mr. Mordy. “They are not like stocks and bonds. They are contracts with finite periods that are very difficult to value.”

Mr. Mordy considers commodity ETFs and ETNs to be highly speculative and not a long-term investment. Agricultural funds carry an extra layer of volatility in the form of weather patterns, he warns. But from time to time he will take a “tactical position,” if macro events such as political upheaval or rising inflation present an opportunity.

Some market watchers warn individuals to step carefully in this space.

“It’s not wise for an average investor to say, ‘Today I am going to own sugar, tomorrow I am going to own cotton,’” says Yves Rebetez, the managing director and editor of ETF Insight, which follows Canada’s $55-billion ETF industry.

Buying a commodity fund is not as simple as buying bank shares, which are a tangible certificate that give an investor the right to receive a portion of any dividends declared in the future. Commodities involve revolving contracts that can “wreak havoc with an investor’s expectations,” he says.

When commodities ETFs and ETNs emerged in 2007 and 2008, institutional investors talked openly about the benefit of adding commodities to portfolios as a means to broaden exposure beyond stocks and bonds. The view was that this was a new asset class to access, but the notion fell apart because commodities markets are a very specialized sector, Mr. Rebetez said.

Numerous Canadian funds have since delisted as a result and most investors stuck with gold or oil and gas, he adds.

But the notion of having some exposure to commodities is reasonable, Mr. Rebetez says. He suggests investors look at newer actively managed ETFs and ETNs where a specialist seeks to reduce the risks.

Invesco PowerShares Capital Management LLC, for example, has developed an “optimum yield” methodology to reduce volatility when contracts roll over by minimizing the negative effects of contango.

Horizons Auspice Broad Commodity Index ETF, for example, mitigates risk by spreading it across up to 12 different commodity futures in the energy, metals and agricultural sectors.

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