Weekly Insight

Commodity futures can spice up your holdings

ROB CARRICK

Monday, March 10, 2008

One of the most effective ways to play the seemingly inexorable rise in commodity prices is also one of the scariest-sounding to the uninitiated.

Futures contracts present a higher level of complexity than stocks and funds, not to mention the risk of ruinous losses. But they also offer several advantages over traditional investments in energy, gold, metals and agricultural products. If you invest directly in a commodity producer, you're assuming the risk that the firm's management will make decisions that negatively affect returns. And unlike futures contracts, the performance of resource stocks and funds are influenced by the general mood on the stock markets.

You'll be relieved to know that you don't have to trade actual futures contracts to invest in commodity futures. An easier way is to buy an investment fund that tracks an index based on the performance of a diversified basket of commodity futures.

The idea of funds investing in the futures market recalls AGF Managed Futures, which was closed in 2007 after losing half its value in a year. But don't let that turn you off the idea of futures. Today, there is a small but growing collection of other choices in futures-based commodity fund vehicles.

One example is the Criterion Diversified Commodities Currency Hedged Fund, a tiny $20-million mutual fund offered by the mutual fund family Criterion Investments. Several other choices are available in the form of U.S.-listed exchange-traded funds and exchange-traded notes, which are a cousin of the better-known ETF.

Two examples of exchange-traded notes are the iPath Dow Jones-AIG Commodity Index Total Return ETN, which trades on the New York Stock Exchange, and the awkwardly named Elements Linked to the Rogers International Commodity Index - Total Return, listed on the American Stock Exchange. Both of these ETNs track broad commodity indexes, but there are more specialized niche products are available.

Commodity-based investments of all types have risen sharply in the past several years, so you're hardly buying low. But with oil and gold both hitting record highs this week, it's clear that there's still a lot of momentum in the sector. If you see this continuing, and there are commodity bulls who do, then it's worth looking at funds and ETNs that expose you to commodity futures.

The Criterion diversified commodities fund is noteworthy in that it offers currency hedging, so your returns won't be affected by changes in the Canada-U.S. exchange rate. Returns are linked to the Dow Jones-AIG Commodity Total Return index, which tracks 19 separate commodities. As of the end of January, the index was weighted 31 per cent weighted in energy, 21 per cent in grains, 20 per cent in base metals, 11 per cent in gold and silver and the rest in co-called "softs" - sugar, cotton and coffee.

The Dow Jones-AIG Commodity Index is based on futures contracts, which set out a price and delivery date for a commodity at a future date. These contracts are continuously "rolled" or, in other words, sold before they reach their delivery date and replaced with new ones.

A benefit of using commodity futures is that they offer the prized attribute of negative correlation to the stocks markets or, in other words, zigging when stocks zag. A study done a few years ago by finance professors at Yale University and the University of Pennsylvania's Wharton School found this to be true over the period stretching from mid-1959 through the end of 2004.

Here's a more recent example: In January, the Criterion diversified commodities fund made 3.3 per cent while the S&P/TSX composite total return index fell 4.7 per cent. "In the quest for non-correlated assets, commodity futures seem to have a great track record," said Ian McPherson, president of Criterion Investments.

Another benefit of commodity futures is that they insulate you from issues that can prevent the returns provided by resource stocks from mirroring the price of the commodity they produce. Mr. McPherson said an example would be the use of hedging, where a company presells some of its production at a set price and thus doesn't benefit if commodity prices soar. Resource stocks can also be held back by unexpected cost overruns and unforeseen events like Alberta's recent decision to raise the royalties paid by energy producers in the province.

The Yale/Wharton study found other benefits to investing in commodity futures. Returns came in at 5 percentage points higher than risk-free Treasury Bills on an average annual basis, and the risk profile was slightly lower than stocks. Also, commodity futures outperformed spot prices, which apply to immediate payment and delivery. The study's conclusion: Commodity futures are an attractive way to diversify traditional portfolios of stocks and bonds.

Exchange-traded notes are one way to get this diversification. Whereas an exchange-traded fund is a direct investment in a stock index, ETNs are bond-like securities that promise the returns of a particular index. ETNs fluctuate in value according to the value of their underlying index, just like ETFs. One way that they differ is in the fact that an ETN will mature at some point (the range is 15 to 30 years from now) at a value determined by the underlying index. There are no interest payments with ETNs, and no guarantee that you'll get your upfront investment back.

Sonia Morris, an analyst with the investment research firm Morningstar Inc. in Chicago, said there's another key difference between exchange-traded funds and notes. Because the notes are essentially debt, the creditworthiness of the backing financial institution is an important consideration. The iPath ETNs are backed by the giant global bank Barclays, while the Elements products are backed by the Swedish Export Credit Corp.

Ms. Morris said her favourite of the commodity futures ETNs is the broadly diversified iPath Dow Jones-AIG Commodity Index Total Return ETN. "I like it because it's not as energy-heavy as the competition. It caps the energy commodities, or any group, to one-third of assets, whereas some of the other supposedly diversified commodity ETNs have as much as 70 to 75 per cent in energy."

If you're more interested in commodity sub-sectors, one to look at is the PowerShares DB Agriculture Fund. This ETF tracks an index called the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture index, which is equally weighted to corn, wheat, soybeans and sugar. Agricultural commodities have been hot lately and this fund has soared by about 25 per cent this year, a contrast to the small losses posted by major stock indexes.

This is a classic example of the negative correlation that makes investing in commodities futures so attractive. Tempted to get it working in your portfolio? If so, be wary of commodities overload. Remember, your conventional mutual funds, ETFs and individual stock picks may have lots of exposure to the resource sector already. Also, let's not forget that commodities have come a long way in the past few years. They could go higher, but it's a long way down.

THE FUTURES OF COMMODITIES

Here's a selection of investment funds that allow investors to get exposure to commodities through the futures market rather than through the shares of individual companies that produce oil, metals and agricultural products.

Note: the iPath, Elements and PowerShares families also offer products for sector commodity investing.

*N=New York Stock Exchange; A = American Stock Exchange

SOURCE: AIG FINANCIAL PRODUCTS CORP.

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