Do your research before taking the plunge with exchange traded commodities.
Back in the third quarter of 2009, the exchange traded commodities (ETC) concept stumbled into crisis.
Between them, the US regulators and the commodities exchanges threatened to impose position limits on US funds, such as United States Natural Gas (UNG) and United States Oil (USO). This meant that the mechanism for the largest ETCs to track their indices was broken. The funds began to trade at substantial premiums (up to 20% in September) to the indices.
Potentially, this action in the United States threatened the future of ETCs all over the world, because of the importance of the US commodity exchanges.
Crisis averted?
Then the whole ETC crisis seemed to come off the boil. The fund sponsors found ways around the position limits problem, the premiums fell steeply but commodity futures indices were rising so the fund share prices held fairly steady.
Nevertheless, UNG and its closest UK-listed equivalent ETFS Natural Gas have still managed to achieve a negative return of almost 50% over the last 12 months.
Since then, there's been long silence on the position limits debate but comment on ways to invest in ETCs has continued. Basically, the credentials of standard ETCs (i.e. ones that track near-month futures contracts) as being in any way comparable to, say, a FTSE 100 tracker, has been shown to be an illusion. Instead, more attention is being given to ETCs that follow more astute strategies.
One further drawback to standard ETCs is the suspicion that commodities traders may have been exploiting the funds' highly predictable behaviour of always investing in the next month's futures contracts. They could be pushing up the contract prices just before the funds have to 'roll-over' into them.
To me, even the improved ETCs are still a mechanism for having your cash translate into commodity futures contracts and back into cash, over and over again. ETCs look as if they're an investment you can buy and hold but underneath they're a form of frequent trading.
Steering clear
Despite all the arguments against ETC investing, commodities may recommend themselves as a way of diversifying a portfolio. In which case, it seems a lot safer to stick with ETCs that track indices of baskets of commodities rather than individual ones such as natural gas, copper or corn.
Even though the direction of spot price of, say, crude oil, may seem a no-brainer, there almost never seems to be a direct translation into rises or falls in the relevant futures index. Hence I'm averse to single commodity ETCs.
As well as keeping well away from ETCs for individual commodities, I'd be even more averse to short or leveraged ETCs.
I remain a fan of physically-backed ETCs in precious metals, especially gold, but I don't expect the price to go up rapidly now.
As an aside, it's also worth checking out the index before investing in an ETC that track commodity futures, as well as details in the sponsor's literature about how they expect issues like contango and backwardation to affect performance.
Baskets of commodities via ETCs
For UK investors there are three main ETCs that invest in baskets of commodities futures.
Two of them, Lyxor ETF CRB Index (LSE: LCTY) and ETFS All Commodities DJ-UBSCISM (LSE: AGCP), have performed similarly over the last two years despite tracking different commodity indices.
I still prefer the third contestant, db X-tracker's DBLCI-OY Balanced ETF (LSE: XDBC). It follows the Deutsche Bank Liquid Commodities Index – Optimum Yield, and definitely qualifies as a more astute approach to commodity futures investing, though it's been around for a couple of years now. Although it's performed worse than its rivals in the last few weeks, longer term I still prefer it.
For investors who wish to avoid investing in energy commodity futures, another option is Lyxor ETF CRB Non-Energy (LSE: LCNE). This would make sense if you believed you had enough exposure to energy through individual oil equities or a FTSE tracker; alternatively, it could be used in conjunction with an oil equity ETF like db X-tracker's DJ STOXX 600 Oil & Gas (LSE: XSER).
There's also ETFS Ex-Energy DJ-UBSCISM (LSE: AIGX); this trades in dollars but the returns would be similar to the Lyxor fund, after one had converted the selling price back into sterling.
It's worth remembering that all these ETC investments effectively give you exposure to the dollar, even if the trading currency of the ETC is sterling or euro.
An open-ended fund approach
At present there is a lone UK investment fund that specialises in actively investing in ETCs, the Marlborough ETF Commodity Fund.
Interestingly, db X-tracker's DBLCI-OY Balanced ETF makes up about 19% of its portfolio and holdings in db X-tracker's DJ STOXX 600 Oil & Gas and DJ STOXX 600 Basic Resources (LSE: XSPR) together comprise a further 12%. However, even discounting its 5% initial charge, it has an expense ratio of 2% plus the expense ratios of its constituents to consider. The ETCs and ETFs mentioned above have all outperformed it.
More on ETFs:
