The search for alternative assets for diversifying investment portfolios has created a demand for "financial engineers" to design and bring to market a wide range of instruments that are promoted as the tool to use.

Commodity exchange-traded funds (ETFs) fall into this category. ETFs are easily accessible, have identifiable strategies and transparent portfolios, which tends to give a false sense of security in terms of their use as a portfolio diversifier. An ETF may be incorrectly chosen, for example, over a less accessible managed futures asset class.

Commodity ETFs are beta driven instruments that seek to generate returns solely from the market, with minimal dependence on manager skill. This gives a commodity ETF a long-only bias, and if the ETF uses futures as the vehicle, further complications will result. Commodity futures are derivatives and have a limited lifespan. An ETF that offers futures contracts under the premise that the underlying asset will rise in value will be subject to an obstacle that is known in the futures industry as "contango."

Contango exists in futures markets of underlying assets that are not perishable. Gold and oil are examples of this type of market. This condition exists when the futures price of one of these underlying assets is higher than the price that exists in the cash market. This situation can be seen when a series of futures contracts' delivery dates show a greater price in each subsequent futures contract. As the current futures contract approaches expiration and the price of the futures and cash markets converges, the long commodity ETF, by mandate of its investment policy statement, will be required to close out the current position and roll into a futures contract with a delivery date further into the future.

Contango will erode the returns of the ETF because the contract price of the position that is closed will be lower than the price on the new position that is opened. The spread between these two positions does not exist in the spot markets.

Commodity ETFs that take positions in normal futures markets will be able to profit from the rollover effect. This effect is known as "backwardation," which exists when a series of futures contracts have a declining slope of prices. John Maynard Keynes defined this condition as normal. His reasoning was based on the increasing cost of carrying a basket of goods to be held until the progressively later delivery date arrives. Contango is the opposite of backwardation and will occur during times of perceived shortages or sudden increased demand for the underlying assets.

Managed futures programs operated by commodity trading advisors operate under a different set of conditions. These strategies seek alpha returns and are far more flexible than a long-only approach. A CTA can buy or sell a futures contract on a given commodity with no short-tick rule or other restrictions that favor a long-only bias.

In addition to this flexibility in directional positioning, a CTA is able to diversify the risk associated with futures trading by entering into several non-correlated futures markets. Holding a portfolio of futures contracts in this way both protects the overall equity in the managed account and enhances returns. Simply consider taking long positions in both sugar and gold. These two commodities have very little in common and are subject to the influences that affect each one and are not influenced by the same macro influences that are felt in markets such as fixed income and equities.

Portfolio diversification is clearly done well when the correct set of asset classes and strategies is implemented. It is prudent to understand the workings of the various strategies and the factors that can affect the overall performance. The operational risk of beta-designed instruments can create additional risks to the overall portfolio when not recognized.

Jeffrey L. (Jeff) Stouffer is the principal of Mercantile Capital Group, a Herndon VA based introducing broker registered with the CFTC and a member of National Futures Association. He has earned the privilege to use the CFP® and CAIA marks, and holds several FINRA licenses. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. He can be reached at [email protected]