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

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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

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 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

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 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

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 Where Do These Returns Come
From?

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 The Ghost of Commodity Futures’ Past
 Returns mostly came from the futures investment strategy, not from
the commodity prices themselves

source: Gorton & Rouwenhorst (2005)

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 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

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 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!

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 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

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 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

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 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

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 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

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 Looking to the Future

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 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

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 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

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 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

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 Intelligent Long-Only Indices Offer Better
Returns
230
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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
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-0
-0

-0

-0

-0

-0
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g-

g-

g-

g-

g-
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b-
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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

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 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

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 Long-short indices following momentum strategies provided one of the
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few sources of diversification during the period of 2007-2009
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 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

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 Investment Outlook

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 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

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 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

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 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

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 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

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 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

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