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How to Build a Hyperinflation Portfolio
Posted by Wealth Wire - Wednesday, September 26th, 2012http://www.wealthwire.com/news/finance/3902?r=1
The threat of hyperinflation in our current economic state is very minimal, though it is true that the U.S. is currently at the highest risk for
such a phenomenon among major developed countries. Preparations for
a hyperinflationary environment have heated up among some investors in
recent years, as the consistent money printing from the Fed has many
worried that inflation will spike at some point in the near future. For
those who fear a major jump in inflation, we outline an all ETF
portfolio to protect yourself from the havoc that inflation can wreak on
your holdings.
Portfolio Snapshot
First things first, here are the ETFs that we have chosen for this particular portfolio.| Ticker | ETF | Asset Type | Allocation | Expense Ratio |
|---|---|---|---|---|
| IEZ | iShares Dow Jones U.S. Oil Equipment & Services Index Fund | Domestic Equities | 10.0% | 0.48% |
| MOO | Market Vectors Agribusiness ETF | Domestic Equities | 10.0% | 0.59% |
| GDX | Market Vectors TR Gold Miners ETF | Domestic Equities | 10.0% | 0.55% |
| HAP | Market Vectors Hard Assets Producers ETF | Domestic Equities | 10.0% | 0.65% |
| TBF | ProShares Short 20+ Year Treasury | Inverse Fixed Income | 10.0% | 0.95% |
| TIP | iShares TIPS Bond Fund | Fixed Income | 10.0% | 0.20% |
| GLD | SPDR Gold Trust | Commodities | 20.0% | 0.40% |
| DBC | PowerShares DB Commodity Index | Commodities | 20.0% | 0.83% |
| Weighted Average Expense Ratio | 0.59% | |||
As can be seen above, there are really only two funds that are
unrelated to the commodity industry. This is because commodities have
been historically strong assets for fighting inflation, leading us to
choose two direct commodity products, as well as four others that invest
in commodity producers.
Holdings Overview
Below is a brief overview of each component of this portfolio.- IEZ: This ETF invests in companies that are suppliers of equipment or services to oil fields and offshore oil platforms, such as drilling, exploration, engineering, logistics, and platform construction. IEZ has more than 40 individual holdings, including companies like Schlumberger and Halliburton. Companies engaged in activities related to oil drilling often see increases in demand for their services during periods of high inflation.
- MOO: This ETF invests in companies that generate the majority of their revenues from the business of agriculture, including agricultural chemicals, operations, equipment, and livestock. The legendary Jim Rogers recently advised investors to “sell your houses, move to Saskatchewan, buy a tractor and some farmland, and start farming,” as he anticipates an “inflation holocaust” sending agriculture prices skyrocketing.
GDX: This
ETF invests in companies engaged in mining for gold, and has
significant holdings in Canada, South Africa, the U.S., Australia, the
UK, and Peru. Since gold generally performs very well in inflationary
environments, companies engaged in its discovery tend to see increases
in revenue as well [see also Three Reasons Why Gold Is Overvalued].- HAP: This ETF tracks an index developed in conjunction with famed commodity investor Jim Rogers, and invests in companies engaged in the production and distribution of hard assets and related products and services. HAP’s holdings include companies engaged in the energy, agriculture, precious metals, and industrial metals industries. This ETF has investments in more than 40 countries, with the most significant being the U.S., Canada, and the UK.
- TBF: This ETF offers inverse exposure to the Barclays Capital 20+ Year U.S. Treasury Index. Since Treasuries tend to lose value in hyperinflationary environments, this ETF provides an opportunity to profit from drops in value. It is noted that TBF uses complex financial instruments to achieve inverse exposure. As a result, compounding of returns may lead to erosion of returns over extended periods of time. To avoid this, investors should develop and implement a rebalancing plan.
- TIP: This ETF invests in Treasury Inflation-Protected Securities (TIPS). These securities provide protection against inflation because the principal of a TIPS rises with inflation, as measured by the Consumer Price Index (CPI). Unlike most traditional fixed income investments, TIP offers a guaranteed real return that will not be eroded in a high inflation environment.
- GLD: This ETF invests in and physically stores gold bullion. Gold has historically been a very strong inflation hedge, appreciating in value as investors seek refuge from other depreciating currencies. Unlike equities or bonds, gold has no potential for dividend or interest payments, so any returns will be generated through increases in the market price level of the metal [see also Why No Investor Should Own GLD].
- DYY: This ETN offers leveraged exposure to a basket of futures contracts, including wheat, corn, light sweet crude oil, heating oil, gold, and aluminum. In hyperinflationary environments, prices for these commodities can be expected to rise, pushing up the value of this product.
Historical Return Analysis
| Ticker | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|
| IEZ | -58.7% | -63.6% | 31.8% | -7.6% |
| MOO | -50.9% | 58.7% | 23.0% | -11.4% |
| GDX | -26.1% | 36.7% | 33.9% | -16.1% |
| HAP | n/a | 42.5% | 16.5% | -11.7% |
| TIP | -0.5% | 9.0% | 6.1% | -29.6% |
| TBF | n/a | n/a | -12.4% | 13.3% |
| GLD | 5.0% | 24.0% | 29.3% | 9.6% |
| DBC | -31.7% | 16.2% | 11.9% | -2.6% |
| Portfolio | n/a | n/a | 18.1% | -4.9% |
| Compare to SPY | -36.7% | 26.3% | 15.0% | 1.8% |
| Compare to AGG | 7.6% | 3.3% | 6.4% | 7.7% |
The adjacent table provides historical results for each component of
this portfolio, as well as backtested results (as available) for the
entire portfolio during 2008, 2009, 2010, and 2011. The table also shows
how this portfolio performed relative to a popular stock market
benchmark (SPY) and bond benchmark (AGG).
Not surprisingly, the components of this portfolio struggled in 2008
amidst a broad market recession. In 2009 and 2010, the equity holdings
in this portfolio reclaimed much of the ground lost during 2008. The
dismal equity returns in 2008 highlight the importance of maintaining an
allocation to fixed income ETFs in this portfolio.
The recent economic downturn also had a significant impact on
commodity prices, as evidenced by the loss of DBC over the most recent
year. TIP has remained relatively stable during the recent market
turmoil, as has GLD, which is the top performer during the last three
years.
Portfolio Expenses
Although this portfolio is not intended to be held over an extended
period of time, we made an effort to minimize costs in selecting the
individual components. Since many ETFs in this portfolio are not “plain
vanilla” funds, they maintain expense ratios higher than some
exchange-traded products. But while the weighted-average expense ratio
falls on the higher side of ETF investing, it remains well below fees
charged by traditional actively-managed mutual funds (which can exceed
1.0%). The impact of this reduced cost structure over a two-year time
horizon is significant [see also The Ten Commandments of Commodity Investing]:
| Growth of $1 Million Over 2 Years @ Annual Return Of | ||||
|---|---|---|---|---|
| Portfolio | Expense Ratio | 5% | 10% | 15% |
| Black Swan Hyperinflation Portfolio | 0.59% | $1,090,187 | $1,197,099 | $1,309,011 |
| Actively-Managed Mutual Fund Portfolio | 1.00% | $1,081,600 | $1,188,100 | $1,299,600 |
While this can certainly be used as an all encompassing group of
holdings, those wishing to protect themselves from inflation can also
use this model portfolio as a smaller part of their overall group of
holdings. It should also be noted that this portfolio is useful in any
kind of inflationary environment not just hyperinflation.
*Post courtesy of Jared Cummans at Commodity HQ.Five Surprising Facts About Hyperinflation
Five Surprising Facts About Hyperinflation
Inflation is a common environment for most economies as prices
tend to rise as time passes. Governments and central banks around the
world mold policies in an effort to curtail inflation and keep it under
control. Another less common phenomenon is deflation, or the general
decline in prices (and wages) and inflation rates fall below zero. Still
an even more rare event is hyperinflation, an issue that does not ail
nations often, but when it does, it leaves behind significant damage.
For those unfamiliar with hyperinflation and its impact on a surrounding
economy, we outline five surprising facts about the phenomenon [see
also Doomsday Special: 7 Hard Asset Investments You Can Hold in Your Hand].
- Results from large increase in money supply: Most often, hyperinflation is a direct result of a large increase in the money supply of a particular nation. When a bank begins to print money, the currency quickly becomes devalued, leading to a deadly spiral in which more money is require to fund government activities (sound familiar?). This leads to an increase in prices around said nation that only continues to accelerate. Though there is no specific benchmark for hyperinflation, many economists feel that it can be described by monthly inflation of more than 50%. At those rates, a $10 CD today would cost you around $1,300 in just one year.
- Lack of confidence in currency: Working off of the last point, hyperinflation is also caused by a general lack of confidence in a particular currency (this one sounds familiar too). When consumers do not trust a currency it can quickly lose its value, especially as investors look elsewhere to store their capital. Note that this process only works in fiat currencies, as printing money at will (only a possibility of paper money) causes people to rightly question the value of said currency. Though the U.S. has long been off of the gold standard, many analysts and investors are calling for a return to a backed currency given the risks associated with paper money and the Fed’s ability and willingness to print dollars at will [see also Commodity Plays For the End of Fiat Currency].
- More closely linked to deflation than inflation: This is one of the more surprising facts that investors learn about hyperinflation. Common sense would tell you that the name “hyperinflation” simply suggests a very extreme case of inflation. While this is technically true, hyperinflation is more closely related to deflation, as many view it “as the result of a failed attempt at printing money to avoid the deflation that would be caused by austerity” writes Max Nisen.
- Hyperinflation still occurs today: Many of the examples of hyperinflation date back to the early 20th century or in post-WWII period, so many associate this phenomenon with history. Unfortunately, hyperinflation is still a very real threat to some countries and currently afflicts economies around the world, with the chief example being Zimbabwe. Following a civil war and major confiscation of farmland in the mid to late 2000s, this nation endured (and is still enduring) unfathomable hyperinflation with its peak annual inflation rate clocking in at 6.5 quindecillion novemdecillion percent. For those of you keeping score at home, that is the number 65 followed by 107 zeros. “To get a handle on it, realize that it’s equivalent to inflation of 98% a day. Prices double every 24.7 hours. Shops have simply stopped accepting Zimbabwean dollars” writes Steve H. Hanke. The nation has since abandoned its previous currency as it was deemed entirely irrelevant [for more commodity news subscribe to our free newsletter].
- The U.S. is currently the largest hyperinflation risk: If you did not already pick up on the hints above, the U.S. has been exhibiting early habits of countries that fall into hyperinflation for quite some time now. Though the risk of this actually coming to fruition is very small, UBS recently stated that “A significant deterioration of the fiscal situation or a significant expansion of the monetary policy stance in the large-deficit countries could lead us to increase the probability we assign to the risk of hyperinflation”. It’s probably something that we will never have to deal with, but it should be noted that the our nation is currently at risk for future hyperinflation.
Don’t forget to subscribe to our free daily commodity investing newsletter and follow us on Twitter @CommodityHQ.
Disclosure: No positions at time of writing.
This entry was posted in Academic Research, Asset Allocation, Inflation and tagged CPI, TIP. Bookmark the permalink.
Commodity HQ is not an investment
advisor, and any content published by Commodity HQ does not constitute
individual investment advice. The opinions offered herein are not
personalized recommendations to buy, sell or hold securities
or investment assets. Read the full disclaimer here.
Related News Stories
Three Reasons Why Gold Is Overvalued
The past few months have put gold
in the spotlight, and for good reason. The metal has shot up from below
$1,000 per ounce in 2009, all the way to its current levels above
$1,500. As markets around the world continue to falter, gold has seen a
massive amount of inflows as it has long been the popular safe haven
investment. Now that the Swiss franc is pegged to the euro, many
consider gold to be the last remaining safe haven, as the once strong
franc will now be dictated by the movements of the drowning euro. But
with gold seeing its price nearly triple in the last several years, many investors are formulating strong opinions as to whether or not the precious metal is overvalued and due for a huge correction in the near term [see also Jim Rogers Says: Buy Commodities Now, Or You’ll Hate Yourself Later].
In the current market environment,
equities are exhibiting extreme volatility, and bonds yields are at an
all time low, forcing investors to find their returns elsewhere. With so
much instability, and the strong returns that gold has posted, it makes
sense that it has surged in popularity over the last three years. Yet,
as the commodity continues to climb, it has become clear that it is
overvalued by some metrics. (By the way, if you’d like to get free daily
updates on gold, silver, and other hard asset investments, consider subscribing to Commodity HQ’s free daily e-mail newsletter.)
Below, we outline the specific reasons why gold’s price is inflated,
and what makes this asset class one that investors need to keep their
eye on for bubbles in the near future:
1. Gold is Gold is Gold
Let’s
look at the facts. Gold is finite mineral that is considered a rare
find, giving it such a high price per ounce. It does not pay dividends
and it has no underlying benchmark, it simply sits in lumps in vaults
all over the world. The past few years has not seen a massive change in
the amount of gold in existence; if there were to somehow be a massive
loss of gold around the world, it would certainly make sense to see its price skyrocket.
Instead, the metal is just as rare today as it was 20 years ago, you
could even argue that with all of the mining giants around the world
that gold has become more abundant [see also Warning: Ignore Bill Gross’ Hard Money Prediction At Your Own Risk].
Nothing about gold has changed in the last few years, so why the
massive appreciation in price? Any other commodity, like lumber or
cotton, that saw this kind of exponential jump would be under major
scrutiny. And cotton, in fact, did bottom-out
after seeing its highest prices in history, putting it at the top of
headlines for quite some time. Investor speculation and market scares
have all contributed to gold’s meteoric rise, and if equities were ever
to get their act together, gold would be in for a massive sell-off. Its
price is held up by flimsy markets and a cloudy future, but if skies
were to ever clear for our economy, investors would pile into equities,
leaving the inflated gold to plummet.
2. Gold is Overbought
One of the most popular benchmarks for gold investment comes from the SPDR Gold Trust (GLD),
an ETF that offers exposure to physical bullion. Looking at the average
volumes of GLD, it is clear that the metal has been overbought as of
late. In August of 2011, GLD had an average daily volume of 33.4
million, which is a huge increase compared to ADVs of 7.4 million and
9.8 million in August of ’09 and ’10, respectively. In fact, last month
saw an astonishing increase in volume of over 244% from the previous
year’s August and 351% compared to August ’09, leaving screaming
evidence of the unnatural volumes
in gold. Because markets have been so abysmal, gold has seen an
extremely high amount of trading, but this is not the first time gold
has seen this kind of move [see also Doomsday Special: 7 Hard Asset Investments You Can Hold in Your Hand].
3. Portfolio Rebalancing
As pointed out by Simon Oates
from Financial Expert, gold may be poised for a loss simply based on
the portfolios of a number of individuals and institutions alike. When
it comes to portfolio allocations, a well-diversified basket of holdings
is key, and that means that investors will try and spread their
exposure across numerous asset classes. Commodities, like gold, are
typically given a small portion of a portfolio usually ranging between
5% and 10% of total assets. However, for those investors lucky enough to
have held a product like GLD over the last five years, they have seen
not only massive gains, but now a major increase in their commodity
allocations as well [see also The Guide To The Biggest Companies In Every Major Commodity Sector].
As a result, gold, an asset that is often meant for the “buy and
hold” investor, now makes up a much larger percentage of many portfolios
than what was originally planned. While investors are likely very aware
of this, it is difficult to sell out of an asset that has multiplied so
rapidly in recent years. Soon enough, however, it will come time to
scale back on the now too-large commodity allocations and prompt a
healthy rebalance. This could send gold for a massive drop as a number
of investors sell out to keep their portfolio reasonably diversified and
avoid putting too much in the precious metal.
Final Thoughts
One of the most important things to remember is that while gold may
be overvalued, that does not mean that it is a bad investment, but is
rather a factor to keep an eye on. It would be absurd to call gold a bad
investment given its historic gains in recent years, but that also does
not mean that it is safe at its current levels. For as long as market
volatility persists, gold will be able to keep its high prices afloat,
but when the day comes where equities finally break ground, this shiny
metal will likely suffer a massive drop. When that will happen though,
could be anywhere from one year to decades depending on who you ask.
Instead, investors simply need to keep a close eye on their gold
holdings, and be ready to pull the trigger if and when our economy pulls
itself out of its downward spiral and confidence once again returns to
the markets [see also Major Countries Burn Up Crude Reserves: Big Oil In Trouble?].
Don’t forget to subscribe to our free daily commodity investing newsletter and follow us on Twitter @CommodityHQ.Disclosure: No positions at time of writing.
This entry was posted in Asset Allocation, Commodity ETFs, Exclusive, Gold, Inflation, Precious Metals and tagged GLD, Gold. Bookmark the permalink.
Commodity HQ is not an investment
advisor, and any content published by Commodity HQ does not constitute
individual investment advice. The opinions offered herein are not
personalized recommendations to buy, sell or hold securities
or investment assets. Read the full disclaimer here.
Related News Stories
Why No Investor Should Own GLD
Those looking for a reason to add commodity exposure to their portfolio will find gold’s massive historical return
to be heavily persuasive. This precious metal has quickly become one of
the few safe haven investments left on the market as investors will
typically flock to gold when equities falter. Some swear by futures
contracts, while others are more partial to obtaining their gold
positions by investing in the mining sector, which can offer offer
lucrative opportunities as these securities often have high betas.
Still, others have embraced exchange traded products as their primary
means of establishing a position in this commodity [see also Three Reasons Why Gold Is Overvalued].
No ETF has been more instrumental to gold’s rise than the SPDR Gold Trust (GLD),
which just so happens to be the second largest ETF in the world by
assets. With over $70 billion in AUM and an average daily volume topping
11.9 million, GLD has established itself as an investor favorite and as one of the most popular funds around. But the fund is not without its drawbacks
and for those looking to establish long term exposure to gold, there is
one fund that offers a more enticing investment thesis, the COMEX Gold
Trust (IAU).
The Gold Case
First and foremost, this is not an article bashing GLD. This has
nothing to do with some of the outlandish speculation that GLD actually
holds no gold or any other conspiracy involving this ultra-popular ETF.
Instead, this article is dedicated towards long term investors who are
seeking to add gold exposure to their portfolio. It is also important to
note that the article is specifically designated towards “buy and hold” investors, not traders.
If
it seems like these two funds are nearly identical on the surface, its
because they are. Both funds track physical gold bullion with GLD
representing approximately 1/10th an ounce of gold while IAU represents
about 1/100th an ounce of the precious metal. When it comes to
liquidity, GLD takes the cake. The fund has a very active options
market, almost eight times the assets of IAU, and a daily volume that is
nearly double its smaller competitor. This makes GLD a prime trading instrument
and it has certainly produced massive returns for a number of
investors. But as it was stated earlier, this article focuses on
long-term investors, where IAU has a clear edge [see also Does GLD Really Hold Gold, Or is it a Scam?].
After all is said and done, it all boils down to a few measly basis
points; IAU charges 0.15% less than GLD, making it the ideal long term
hold. Think that number sounds insignificant? Consider two different
million dollar portfolios, one which is wholly invested in GLD and the
other doing the same for IAU (obviously a diversification nightmare but
stick with me). The GLD portfolio will incur annual expenses of $4,000,
while its competitor will shell out only $2,500. That $1,500 difference
seems miniscule for just one year, but drag it out over a 30 year
investment and the difference between fees amounts to $45,000, or 4.5%
of your original investment. Saving yourself a quick 4.5% could have
been as simple as buying IAU over GLD.
Also consider that IAU’s cheaper fees will mean that it will generally outperform its competitor.
Though the difference will be slight, there will be a noticeable delta
between the two when the time frame is expanded to multiple decades.
Note that GLD’s size and trading volume can tweak these numbers a bit,
but evidence shows that assets may be headed towards IAU, which could
erase this issue in time. IAU slashed its expense ratio in mid 2010,
making 2011 its first full trading year at 0.25%. Last year, IAU saw
cash inflows of over $2.7 billion, while GLD saw outflows of
$372 million, suggesting that long term investors have begun to catch on
to the money saving trend between these two ETFs [see also Seven Reasons To Hate Gold As An Investment].
Final Thoughts
As mentioned earlier, GLD is likely the supreme trading instrument
for more active investors. The fund offers unmatched liquidity and a
strong options market. But when it comes to long term investors, IAU
emerges as a clear winner. With a wide range of individuals and analysts
predicting gold’s rise to continue through out the years, a number of
investors have added exposure to their retirement accounts or at least
some kind of long term basket of holdings. For those who have adopted a gold strategy that will stretch over multiple years, consider the money that could be saved with IAU and the difference that a few seemingly insignificant basis points can make.
Don’t forget to subscribe to our free daily commodity investing newsletter and follow us on Twitter @CommodityHQ.
Disclosure: No positions at time of writing.
This entry was posted in Commodity ETFs, Exclusive, Gold, Precious Metals and tagged GLD, Gold, IAU. Bookmark the permalink.
Commodity HQ is not an investment
advisor, and any content published by Commodity HQ does not constitute
individual investment advice. The opinions offered herein are not
personalized recommendations to buy, sell or hold securities
or investment assets. Read the full disclaimer here.
Related News Stories
The Ten Commandments of Commodity Investing
Investor interest in commodities has surged in recent years,
the result of both a prolonged rally in natural resource prices and the
development of new vehicles that facilitate access to this asset class.
Specifically, the launch of a robust lineup of exchange-traded products
that utilize both physical commodities and commodity futures contracts
has brought commodities to the masses; they’re no longer reserved for
the largest and most sophisticated investors [see also Jim Rogers Says: Buy Commodities Now, Or You’ll Hate Yourself Later].
Commodities have obvious appeal to active investors looking to
generate profits from short-term price movements; the volatility of this
asset class is ideal for risk-tolerant individuals who actively monitor
their positions. But commodities may also have appeal to the long-term,
buy-and-hold crowd;
this asset class has the potential to bring both diversification and
return enhancement to traditional stock-and-bond portfolios.
Of course, along with those potentially appealing attributes comes
plenty of risk; the path to commodity exposure is full of potential
obstacles and pitfalls that can erode returns and lead to a
less-than-optimal investing experience. Here are ten rules of thumb that
will help you achieve a more successful experience investing in commodity markets [see also Warning: Ignore Bill Gross’ Hard Money Prediction At Your Own Risk]:
1. Remember the Contango…
Perhaps the most common–and most dangerous–misconception about
commodity ETFs and ETNs is that these products offer investors exposure
to the spot prices
of the underlying commodities. While some physically-backed precious
metals ETFs such as IAU and SLV do hold physical bullion, the vast
majority of commodity ETPs on the market achieve the targeted exposure
through the use of futures contracts.
That is very important to note, because it means that the returns generated will ultimately depend on three factors:
- Changes in spot price of the commodity
- Slope of the futures curve
- Interest earned on uninvested cash
It’s not uncommon for the second point on that list to be the driving
force, and the reason why returns on commodity ETPs can deviate
significantly from a hypothetical investment in the spot commodity [see
also 25 Things Every Financial Advisor Should Know About Commodities].
2. …And Keep It Away
For an investor who solely invests in futures contracts, contango may
not be as big of an issue. But given the fact that commodity ETPs have
soared in assets in recent years, there are a large amount of people who
rely on these products for their commodity exposure, and it is highly
likely that a number of them have been burned by contango.
A futures-based ETP follows a strict process which, when combined with
contango, slowly but surely destroys a position. The most popular kind
of commodity exchange traded product is a first generation futures fund;
one that simply invests in front-month futures and features an
automated roll process. Here is where the issue comes into play.
When and ETP’s contract is about to reach maturity, the fund executes
an automated roll process so as to avoid delivery. When futures are
contangoed, this forces the particular fund to sell the contract low,
and buy the next contract for a higher price, erasing value with the
blink of an eye. When this process is dragged out over several months,
these funds have a nasty habit of producing some rough returns. But how
can you keep away from such a common anomaly?
It is first important to remember that first-generation futures
funds, like UNG and USO, should be used as trading instruments. Their
automated roll process will always fall prey to a contangoed
environment, and therefore it is not often wise to establish a long term
position in such a fund. Instead investors should measure their holding
periods of these products in days and hours, rather than weeks and
months, to help avoid the pitfalls of the auto-roll. But for those who
are uncomfortable with actively trading a fund, there are now a wide
variety of ETPs that are focused on eliminating contango. These
next-generation products will often hold several futures contracts at
once and their roll process does not always involve buying the next
month’s contract, but rather one that matures further into the future.
A quick glance at the index description of a futures-based fund will
tell you if it is utilizing the dangerous front-month strategy, or if it
is using alternative means to avoid contango. Also note that investors
can use physically-backed products to avoid this issue, though that space is generally limited to precious metals [see also .
3. Do Not Bear False Witness Against Commodity ETNs
Most investors are aware that there are distinctions between
exchange-traded funds and exchange-traded notes; ETFs hold a basket of
underlying securities and may experience tracking error, while ETNs are
debt securities that will expose investors to the credit risk of the
issuing institution [see also Three Reasons Why Gold Is Overvalued].
Most investors tend to gloss over the differences between these two
product types, since they generally function in almost identical
fashion. When it comes to accessing commodities, however, the
differences between these two product structures can be significant. For
starters, tracking error can become a big issue with products that
regularly “roll” futures contracts to avoid taking physical possession;
ETFs that are continuously buying and selling futures contracts are
likely to deviate slightly
from their target index. ETNs don’t have that concern, since there are
no underlying holdings; the value of these securities simply moves along
with the index.
It should be noted that ETNs can also avoid the fees that come along
with rolling futures contracts and implementing a futures-based
investment strategy. ETFs incur costs in the form of brokerage
commissions whenever they sell or buy futures contracts; ETNs simply
calculate the change in value of the underlying index, and the value of
the note adjusts accordingly [see also 25 Ways To Invest In Natural Gas].
Basically, it is worthwhile to do your homework into the various
structures at your disposal for accessing commodities; the choice you
make can have a potentially significant impact on your credit risk, tax
liabilities, and tracking error. Most investors look at ETNs with
skepticism, wary of the credit risk contained. That risk component
certainly shouldn’t be ignored completely, but it is worth noting that there are some appealing attributes of the ETN structure as well.
4. Know Thy Tax Ramifications
The
issues of tracking error and expenses aren’t the only place where the
choice of structure matters; the difference between a commodity ETF and a
commodity ETN can translate into sizable discrepancies in tax
obligations. Most commodity ETPs that actually hold futures
contracts–meaning the non-ETN segment of the universe–are structured as
partnerships for tax purposes. That means that these securities are
taxed at a blended rate between short-term and long-term capital gains
(the 60/40 split results in an effective rate of about 23%). Moreover,
these securities incur a tax liability annually regardless of whether
shares were sold. And they require advisors to fill out a K-1, which can
be an administrative headache to some [see also Dividend Special: Top Companies In Every Major Commodity Sector].
Compare all of that to the simplicity of commodity ETNs, which are
generally only taxed upon sale at the applicable short-term or long-term
rates. Moreover, commodity ETNs are reported of a form 1099; there’s no
K-1 to deal with on these products.
One other note on the subject of commodities and taxes; it’s
important to note that physically-backed ETPs aren’t the only products
that are subject to some strange rules. For example, it’s important to
keep in mind that physically-backed precious metals ETFs, such as the
ultra-popular GLD and IAU, are subject to being taxes as collectibles
[see also 25 Ways To Invest In Silver].
5. Thou Shalt Not Commit “Energy Bias”
When it comes to commodity investing, many investors commit the sin
of energy bias, whereby the majority of their commodity holdings fall
under the umbrella of an asset like crude oil or natural gas. To be
fair, energy products are among the most popular in the commodity world,
but exhibiting a bias towards these investments can have some adverse
effects on your portfolio. Energy products are quite often highly
correlated to the movement of general markets, meaning that they will
move closely in line with something like the S&P 500. One of the
main reasons that commodity exposure is essential to a portfolio is the
low correlation and diversification benefits that these investments
offer. An energy-heavy portfolio will likely only steepen your losses on
bad days which may not be enough to be erased by days in the black [see
also The Ultimate Guide To Natural Gas Investing].
Energy investments are obviously very important, as the majority of
these commodities offer relatively inelastic demand because we cannot
survive without them in our daily lives. But with these futures and
products being particularly volatile, committing a bias may only hurt
you in the long run. Instead, it is important to remember to keep vital
energy holdings in check with other commodities like precious metals or
softs. This way, a portfolio will still reap all of the benefits offered
from energy, but will also gain the diversity of commodities tied to vastly different price drivers that offer sometimes zero correlation to major benchmarks.
6. Thou Shalt Not Be Stolen From
Commodity investing can be an expensive venture, and if one is not
careful, it can be easy to erase value through expenses like commissions
and other fees associated with trading. One of the first things every
investor should do is take a look at their strategy and then research if
there is a cheaper way to gain the exposure. Often times, there is a
corresponding exchange traded product to a futures-based strategy that
can offer a much more enticing expense structure. The constant shifting
of positions required by commodity investing can quickly eat away
bottom-line returns, as commission fees rack up quickly, not to mention
the capital gains on a short term trade. Failing to consider one’s
expenses is essentially allowing the markets to steal from you [see also
Why Commodities Belong In Your Portfolio].
When considering your commodity trading strategy it is important to
see the bigger picture. Is there a fund that trades the same contracts
for a lower price? Is there a company that offers good exposure to a
commodity that doesn’t require the constant movements that are needed
for futures investing? And most important of all, is there a cheaper way
to employ the same strategy? While a few measly basis points may not
seem like a lot, consider a portfolio of $1,000,000. Let’s say that each
year that portfolio is subject to fees of 1% of total assets (not an
uncommon expense for active traders). If one were to eliminate 0.25%
from that figure, you could save $2,500 every year. Drag that out over
ten years of trading and you have an extra $25,000 sitting in your
pocket. Commodity investing can be expensive, but there are plenty of
ways to beat the fees, it simply takes diligent and careful research.
7. Consider “Indirect” Positions In Commodities
Investing
in commodities generally means holding either the actual physical
natural resources (generally gold or another precious metal) or holding
futures contracts that are linked to the commodity. But there is another
option for tapping in to this asset class that takes an indirect route
to commodities; stocks of companies whose operations revolve around the
exploration, extraction, and sale of commodities. For example, stocks of
gold mining firms can be seen as an indirect investment in gold [see
also The Ultimate Guide To Gold Investing].
These companies tend to exhibit relatively strong correlations to the
underlying resources. That’s because the profitability of these
companies generally depends on the market price for the goods they sell.
In the case of a gold miner, higher gold prices will generally
translate into higher earnings since they will receive more money for
each ounce of the metal they uncover and sell. Similarly, oil stocks
tend to perform well when crude prices climb
and timber stocks do well when lumber prices are elevated. The benefit
of this approach is that stocks don’t exhibit contango that is common in
commodity futures contracts–often to the detriment of positions in
these securities.
It should be noted, however, that stocks of commodity-intensive
companies will not always exhibit perfect correlation with the
underlying natural resource. These stocks are, after all, stocks–meaning
that they will be impacted by movements in broad global equity markets.
That may diminish one of the appealing attributes of commodities; the
potential for diversification benefits and a low correlation with stocks
and bonds [see also Six Academic Studies Every Commodity Investor Must Read].
8. Do Not Covet Thy Neighbor’s Methodology
The old saying is that there is more than one way to skin a cat.
That’s certainly applicable when it comes to investing in commodities;
there are a number of different ways to tap into this asset class. Even
in a futures-based approach to investing in natural resources, there are
multiple options for crafting a commodity position. The details of an
investment in commodities may seem insignificant, but they can actually
end up having a meaningful impact on bottom line returns and volatility.
For any given commodity, there are generally multiple futures
contracts that are distinguished by the maturity date. For example,
there are crude oil contracts traded on the NYMEX expiring each month of
the year. Other futures have four or five maturity points in each
calendar year, and in many cases there are contracts listed for years in
advance (it is possible to, for example, to invest in a crude oil
futures contract that expires in 2015) [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].
Exchange-traded commodity products can generally be categorized into
three groups, depending on which type of futures contracts they hold:
- Front Month Futures
- Rolling 12-Month Futures
- “Dynamic” Futures
Many of the commodity ETPs on the market focus on front month futures
contracts, rolling exposure as the contracts approach expiration and
using the proceeds to invest in the second month futures contracts. The
benefit of this strategy is that front month futures tend to exhibit the
strongest correlation to spot prices in the short term, meaning that
products such as USO and UNG are optimal for those expecting to be in a
position for a short period of time.
The downside is the potential for the adverse effects of contango;
because products that focus on front month futures must roll holdings on
a monthly basis, they are vulnerable to more frequent return erosion
resulting from an upward-sloping futures curve. ETPs that spread
exposure across 12 months of futures contracts, on the other hand, may
not experience the same degree of return erosion since only a fraction
of the portfolio changes each month. In return for that benefit, these
products might not exhibit quite the same correlation to spot prices
[see also.
Finally, there are a growing number of ETPs that don't stick to a
predetermined roll strategy, instead examining observable market prices
to determine which contracts are optimal for minimizing the adverse
impact of contango or maximizing the benefit of backwardation [see also Should You Buy Gold Before QE3 is Announced?].
While these approaches and the products that employ them may seem
similar, they can lead to very different results. Make sure you
understand the nuances of each strategy before jumping in to a commodity
ETP.
9. Do Not Swear Falsely By The Name “Inflation Hedge”
A
large part of the appeal of investing in commodities is related to
inflation; this asset class is generally assumed to be an effective way
to protect investor portfolios from the adverse impact of inflation.
Because inflation by definition means an increase in prices, this can
obviously be a boost to natural resource prices. Rising prices for
energy, metals, and agriculture results in a higher CPI. While inflation
is generally bad for fixed income and can have an adverse impact on
stock prices as well, the conventional wisdom is that this phenomenon is
a big positive for positions in commodities [see also Invest Like Jim Rogers With These Three Agriculture Stocks].
It is important to understand, however, that not all individual
commodities are equally effective as inflation hedges. Some exhibit a
very strong correlation with indications of rising prices such as the
consumer price index (CPI), while others are not nearly as effective.
That means that for investors concerned primarily with protecting their
portfolios from the ravages of inflation, picking the right commodity
(or commodities) is a key consideration.
A detailed study on the effectiveness of various commodities
presents some interesting conclusions; this piece is certainly a key
resource for those looking to use commodities as an inflation hedge.
10. Thou Shalt Not Neglect A Position
Though estimates vary, as many as 90% to 95% of commodity investors
report losses from their trading activities. Commodities are volatile,
difficult to predict, and as such, can be extremely frustrating
investments. But one sure way to lose money is to simply neglect a
position. While it seems fairly obvious that a lack of monitoring is a
poor choice, the recent influx in commodity ETPs has made this asset
class more readily accessible to those who may not be used to keeping a
watchful eye on their positions [see also ].
A commodity position will typically be measured in hours and days
rather than months and years. Prices can be extremely volatile with
seemingly insignificant events having a major trickle-down effect on the
underlying investment, so the need for active monitoring is vital to
the commodity space. Note that this piece of advice is most applicable
to futures-based investments; there are a select few physically-backed
commodity ETPs as well as equity investments that can be used for longer
term strategies. If you do not have the time to watch your position
through out the day, you probably have no business making the investment
in the first place. Other than VIX contracts, commodities can be some
of the most volatile investments available today and investors need to
proceed with caution [see also The Guide To The Biggest Companies In Every Major Commodity Sector].
On the flip side, actively monitoring will not only avoid losses, but
it will typically lead to gains. Those who keep one ear to the ground
so to speak, will have a much better chance of hopping in and out of
trends intraday and turning a quick profit from the momentum of
commodity markets. Commodity trading is meant to be volatile and for
those who are unable to stomach the risk, it can be a brutal investing
process. As a more general piece of advice, have a profit objective for
each position and be willing to accept your losses when you were wrong. A
sound and stable mind combined with good risk management will lead to
smarter and more effective commodity trades.
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Disclosure: No positions at time of writing.
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