With interest in commodities surging in recent years, it is not surprising that financial advisors are increasingly looking to the commodity sector as an important way to create well balanced portfolios for their clients. As part of a comprehensive investment strategy, investing in commodities not only mitigates risk, but allows for appreciation in value at a time when the global population is growing rapidly and the demand for some critical resources has the potential to grow exponentially. No wonder that many advisors have come to the conclusion that exposure to commodities is essential.
Futures trading may be the most effective way to gain direct exposure to the commodity sector, but let's face it, most clients prefer and understand how to trade stocks, not futures, and only the most sophisticated of investors (including financial advisors) are capable of trading futures effectively without actually adding risk to a portfolio. Most advisors are seeking easy to understand--and easy to explain--investment vehicles through which they can gain direct commodities exposure for their clients. Exchange-traded products ("ETPs") offer just such a vehicle.
ETPs are experiencing tremendous growth, and for good reason. They generally are highly liquid, transparent, affordable instruments through which advisors and their clients can gain exposure to a variety of commodities for both diversification and "profit-generating" purposes. ETP fees are usually a fraction of those charged by mutual funds, and ETPs have price transparency throughout the trading day.
Types of ETPs
The ETP sector includes products structured as both exchange-traded notes ("ETNs") and exchange-traded funds ("ETFs"). ETNs are credit instruments dependent upon two variables: first, the creditworthiness of the issuer and, second, the price movement of an underlying benchmark. Many advisors feel the combined risks of both credit exposure to the issuer and price exposure to the underlying commodity make ETNs less attractive as core portfolio holdings than ETFs--which have little or no credit risk--segregated assets in custodial accounts and, in most cases, transparency of holdings.
ETFs can be securities-based or commodities-based. Securities-based ETFs provide indirect exposure to the commodity sector by investing in the securities of companies in the commodities business, rather than in the commodities themselves.
ETPs offering direct exposure to commodities generally hold either physical commodities or futures contracts. Precious metals ETFs can easily buy and store the underlying commodity, so they generally own the actual commodity. This results in a very accurate tracking of the "spot price" or the physically delivered price, of the commodity.
On the other hand, energy, agricultural, and industrial commodity ETPs must own futures contracts, since their underlying commodities take up a tremendous amount of space relative to their dollar value, are difficult to store, and generally have a limited storage life. These products are subject to the effects of "contango" and "backwardation" which means their performance is less likely to precisely track the spot price of their underlying commodity, but, short of entering the futures markets or trading the commodities themselves, these ETPs offer extremely effective exposure to asset classes critical to constructing a well-balanced portfolio.
Many recently launched ETPs directly address the issues of contango and backwardation; advisors and their clients would do well to research those best suiting their investment needs. In general, ETPs that concentrate their futures holdings in a single futures contract are best suited for short-term trading, and those ETPs with futures holdings that are more diversified across the futures curve - or specifically designed to mitigate the effects of contango or backwardation - are better suited for longer-term investing purposes. Both the websites of sponsors of ETPs, as well as many independent online sources, can provide advisors and their clients with the information they need to make an informed decision about which ETP best suits their investment goals.
Portfolio Diversification (Beta) and Absolute Returns (Alpha) using ETPs
Common wisdom holds that commodities should be an integral part of a core portfolio for some classes of investors. The now iconic study by Yale Professors Rowenhorst and Gorton set the stage several years ago for broad commodities baskets to be included in investment portfolios for "beta," or diversification purposes. A good number of broad-based, diversified commodity ETPs are available to fill this investment need.
In addition, many advisors are now beginning to seek absolute returns through the use of more focused commodity ETFs. These single-commodity products can be used to very effectively overweight or underweight specific commodities held in the core portion of a portfolio.
Precious metal, energy and agricultural single-commodity ETPs can be used to add "alpha," or absolute returns to a portfolio. These commodities are viewed by many as integral to any well-balanced portfolio and often geopolitical and/or supply concerns motivate investors to overweight or underweight these commodities.
Again, there is a good selection of single commodity ETPs from which to choose, and more products are being added almost daily.
Liquidity, Valuation and Order Execution
Commodity ETPs are generally designed for high liquidity, even if the daily average number of shares traded is quite low. The number of shares authorized for issuance is very often a more accurate indicator of the liquidity achievable in most commodity-based ETPs; this information can be found on the website and in the prospectus of the ETP in question.
Although ETPs are valued throughout the day with an active bid/ask market, the spread between the bid and ask can vary depending upon the ETP and the volatility of its underlying holdings. Investors should always check the Intraday Indicative Value (IIV) of the ETP before determining an entry or exit price. The IIV is calculated every 15 seconds by the listing exchange and is an accurate gauge of the ETPs actual value, but it is only valid when the underlying futures market is open for trading, and it is only accurate at the very moment it is calculated.
Importantly, buy and sell orders should always be entered as limit orders, never as market orders in any ETP. Large volume, or block trades can be executed through your traditional execution platform or through a number of execution desks available to advisors from a variety of Broker Dealer participants; advisors should contact their broker-dealer for any execution related questions regarding commodity ETPs.
The growing slate of commodity ETPs gives advisors and their clients an affordable, liquid, easy to trade category of investments with which to gain commodity exposure in their portfolios. With just a little bit of study, advisors can now use ETPs to effectively diversify and enhance their investment objectives within the commodity sector.
Sal Gilbertie is the president of Teucrium Trading, LLC, (www.teucrium.com), an issuer of single commodity focused next generation exchange-traded products, including, the Teucrium Corn Fund (NYSE: CORN), Teucrium Natural Gas Fund (NYSE: NAGS) and the Teucrium WTI Crude Oil Fund (NYSE: CRUD).