A Year Of Extremes

2008 was a year of extremes for the commodities market. The most important commodity in the world economy, oil, rose to a historic high of US$147 per barrel in July, before collapsing in price to around $40 per barrel by year-end. Other raw material prices had a similar roller-coaster ride, although there were substantial divergences in returns between the different commodity sectors. While commodities performed, on aggregate, slightly better than equities over the year, the synchronous price collapse of both from September onwards will have caused many investors to question whether commodities' often-advertised diversification properties exist at all.

The five main sub-indices of the Dow-Jones AIG commodity index gave returns for the year ranging from -4% for the precious metals sub-index to -47% for the energy sub-index. The 2008 returns for the sub-indices, together with the 3,5, and 10 year cumulative returns, ten-year correlations with the DJ Euro Stoxx index, and ten-year annualised daily volatilities, are shown in the table below (data are reproduced from the ETF Securities 2008 Commodities Review). All return figures are in US Dollars.

For all the commodities categories except industrial and precious metals, 2008's declines have effectively wiped out any positive returns on a five-year view. Over ten years, there is a big divergence between the returns from the energy and metals sectors, which have given investors handsome returns, and those from the agriculture and livestock sectors, which have not.

Correlations with equities have been highest for industrial metals (as one might expect, given the direct linkage to economic production), whereas precious metals have shown themselves to be uncorrelated—a big plus for portfolio investors, who spend a great deal of time searching for assets with similar characteristics. This, when combined with the relatively strong returns gold (in particular) has achieved over the last year, explains why investor inflows into this commodity continue to surge.

One complication that a commodity investor runs into immediately is the question of backwardation and contango. In the first case (backwardation), longer-dated commodity futures contracts trade at a lower price than the spot price, meaning that an investor who rolls his commodity futures position from one contract to the next gets to reinvest at a lower price each time, earning a positive roll yield. In contango, forward prices are higher than spot, eating into investors' returns when they roll from one contract to the next.

In order to avoid the negative roll yield associated with commodities trading in contango, some ETF providers offer diversified commodity indices that do not follow a simple rule of tracking the nearest-term futures contract (more on this below). ETF Securities, via its forward ETCs, also offers investors the chance to avoid the traditional rolling of near-term futures contracts and to track contracts 3 months forward from spot. The dramatic difference resulting historically from a change in "roll policy" is visible in the table below, which shows the contrasting returns from the different AIGCI sub-indices and their "forward" counterparts. The precious metals sub-index is excluded, since for these commodities there is typically little difference in the returns achieved by rolling futures contracts as opposed to investing in the metals directly at the spot price.

If the ten-year returns of the 3-month forward indices have outperformed the near-term indices in each case, often by a huge margin, this suggests that the use of the longer-dated contracts has maximised exposure to backwardation (which gives a boost to returns) or reduced exposure to contango.

I asked Nik Bienkowski of ETF Securities to comment on these divergences, and the extent to which investors have made use of the forward commodity ETCs. He pointed out that, while his firm originally introduced the forward ETCs to meet client demand, there is no guarantee that the outperformance of "classic" ETCs by forward ETCs will continue. Bienkowski added as an example that ETF Securities offers ETCs giving access to four different maturities on the oil futures curve, and each one has outperformed at different times.

As far as client use of forward ETCs is concerned, ETF Securities currently has around US$ 90 million invested in them, well short of the peak of $376 million reached last May. Nevertheless, the firm's clients have at times made active use of forward ETCs, most notably ETFS Forward Agriculture (FAGR) and ETFS Forward Natural Gas (NGAF).

At the very least investors need to be aware of the huge differences that variations in roll policy can have on returns, and they must know how to make an informed choice when deciding which part of the commodities futures curve they wish to be exposed to.

Major commodity indices allocate very different weightings to the different commodity categories (see the table below, taken from BGI's December 2008 "ETF Landscape").

It is unsurprising, therefore, that the performance of the broad commodity ETFs offered by leading European ETF providers showed some significant divergences. For easier comparison with the tables shown above, I have calculated returns in USD terms, although the main listings of these ETFs are in Euros.

The heavy Energy weighting in the S&P GSCI index accounts for the EasyETF GSCI fund's bottom-of-the-table performance for 2008, while Market Access's RICI ETF follows closely behind, apparently due to its overweighting of Brent crude and some of the poorer-performing industrial metals like lead and zinc, and its underweighting of the precious metals by comparison with the DJ-AIG and CRB indices.

The db x-trackers DBLCI-Optimum Yield ETF performed relatively better than the other ETFs. The "optimum yield" index uses a formula-based optimisation strategy that seeks to maximise the positive roll yield - minimise the negative roll yield—as it buys and sells commodities. Rather than simply purchasing the near-month contract, or even a contract a fixed number of months out, it evaluates all available contracts and selects the most advantageous month. Deutsche Bank's calculations—admittedly, based on back-testing - show that the DBLCI-OY index methodology has also beaten the GSCI and DJ-AIG indices by a wide margin on a longer-term view as well.

Where have investor cash flows been heading within the commodity sector as a whole? Despite all the interesting intricacies involved in deconstructing the commodities futures curves, most investor funds within the ETF/ETC space have gone straight into gold. Indeed, the three major European gold tracker funds—Gold Bullion Securities, ETFS Physical Gold, and ZKB Gold ETF—now have assets totalling over US$ 8 billion, dwarfing the money invested in other areas. This represents a major success for the relevant ETF/ETC providers—ETF Securities and ZKB—but is must also present them with a challenge, since they would undoubtedly like to diversify their businesses more.

Having said that, the prospects for gold and the other precious metals seem unlikely to dim this year, and indeed they may not for a few years to come. With the credit crunch showing no signs of abating, and government solvency increasingly in question, investor demand for non-fiat currencies seems well underpinned.

After the dramatic fall in commodities prices during the second half of 2008, this year has got off to a stronger start. A number of the diversified ETFs highlighted above have seen decent inflows, investors continue to buy the precious metals (with gold breaching the US$900/ounce barrier again) and, as we have reported in the news section of the site, there are signs of a jump in demand for energy and agricultural ETCs. ETF Securities' recent annual review points to historically low inventories of a number of industrial metals, and also to the fact that global stocks of corn, wheat and soybeans are at their lowest levels since 1974.

So even if the global recession is putting a brake on the demand side for commodities, supply constraints should help to underpin prices. And the bubble-like atmosphere of early 2008 has certainly disappeared, allowing investors to access the sector on more favourable terms. All in all, 2009 should be a better year for commodity ETFs/ETCs.