Active Commodity ETFs: A Smart Move for Inflation Hedge

But investors need to choose wisely when it comes to picking a fund for their commodity dollars.

It turns out that commodity and natural resource investing is best done with an active touch. Indexing of commodity products may now do a good job of providing gains and limiting the effects of backwardation and contango. Luckily, a new crop of active commodity ETFs have launched, allowing investors to win big.

While it’s now in the rearview mirror, the pandemic’s effects are still with us. That comes courtesy of still high inflation. Various supply chain disruptions during the worst of the COVID-19 pandemic created a lack of supply that was met with surging demand. Add in a hefty dose of stimulus and you now have an environment with high inflation.

Central banks have done a good job of reducing inflation. The days of very low inflation or deflation are most likely going to be a fading memory. Longer term, U.S. inflation rates have generally been above 3%.

To that end, many analysts and asset managers have been calling for investors to add commodities to their portfolio. Since they represent the ‘core’ building blocks of our lives, they are directly tied to demand and a growing economy. When we eat more food, cattle, corn, and wheat, prices go up. When we buy more cars, iron ore and crude oil prices surge. It is as simple as that.

Because of this fact, commodities have been wonderful inflation fighters over the long haul. According to investment manager Schroders, commodities have delivered positive beta versus the CPI since the 1970s. Equities and bonds have been negative.

With high and stubborn inflation, it makes sense to add commodities to a portfolio. Historically, natural resources have long been an outlier when it comes to investing for most individual portfolios. That’s due to the fact they are traded via a system of futures, options, and other derivative contacts. However, like many areas of the market, ETFs have made commodity investing easy. With one click, investors can easily access a basket of various commodities.

Today, products like the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF and iShares S&P GSCI Commodity-Indexed Trust hold billions in assets.

But investors may want to rethink how they get exposure to commodities. Indexing may not be the correct answer. That comes down to how they are constructed in most cases.

The issue is that most commodity indexes are production based. When it comes to stock indexes, most sponsors focus on market cap. So, larger firms get a bigger place in the index. With commodities, it’s about production.

The three major indices for commodities—the Goldman Sachs Commodity Index (S&P GSCI), the Dow Jones-AIG Commodity Index, and Bloomberg Commodity Index (BCOM)—all weight their constituents based on how much of a commodity is produced around the globe. This has nothing to do with demand at all. Energy—crude oil and natural gas—gets higher weighting because we produce way more oil globally than we do wheat, aluminum or livestock. That’s the issue when it comes to returns.

Greater supplies and production actually mean lower prices for a set commodity.

Nueberger Berman highlights this fact in the natural gas markets. Since 2000, natural gas production has grown by more than 80%, as shale gas and fracking have come online. Because of this, the previously mentioned BCOM index boosted its share of natural gas futures to 10%. However, over this time, natural gas prices—as Bloomberg Natural Gas Subindex—fell by 99%. Investors basically added more natural gas to their portfolios as prices were crumbling.

Source: NB.com

Then there is the quirky fact of contango and backwardation in the commodity markets. Unless you are actually buying, taking delivery of, and storing a commodity—like Kellogg’s buying wheat to produce cereal—the prices of futures contracts relative to the current market price created a heavy influence on returns. Backwardation isn’t so bad; it’s when commodity futures sell for a lower price than the current market price. A commodity in backwardation provides better returns over time.

However, contango implies that futures contracts sell at a higher and higher premium to the current spot price. As an index sells the current month contract and rolls over to the next month, it pays more and buys less of a commodity. A 1% monthly roll cost comes out to be a nearly 13% loss for the ETF.

On the one hand, commodities make sense as an inflation-fighting tool. On the other hand, using an index fund may not provide actual positive and inflation returns. Many natural resource indexes are poorly constructed.

The answer may be to go active. Like many areas of the market—fixed income, small-cap, emerging markets—active managers can exploit these inefficiencies and generate better returns.

For example, rather than focus on production, they can shift to demand. Higher electrification, E.V., and data center growth mean that copper and other metals have a unique tailwind to them. An active manager may choose to overweight these metals. Likewise, weather conditions, storage costs, and geopolitical conflicts can all impact various commodity pricing and futures potential.

Likewise, managers can avoid those markets in contango or even dig into data differently. A lot of producers will hedge their commodity production and transfer risk. This could provide key insights to how a commodity market is working and future supply/demand issues.

And finally, you get a better return on cash. To buy futures, you need to put up collateral. Often these collateral and maintenance margin requirements are collateralized in T-bills. That might not be a sound strategy as costs could outweigh returns on this cash. Active managers can employ cash management techniques to improve returns on their funds.

These ETFs were selected based on their active exposure to the commodities futures market. They are sorted by their YTD total return, which ranges from 5.4% to 8.7%. They have expense ratios between 0.55% to 0.84% and assets under management between $10.6M to $280M. They are currently yielding between 0.7% and 6%.

Overall, commodities is a dish best served via active management. Poor index construction and some naturally occurring effects of the futures/spot market make it difficult for passive investors to win in the area. With natural resources being cited as a great inflation hedge, the time to get active and add them is now.

For investors, going active via ETFs makes a ton of sense in the commodity space. Thanks to poor index construction, passive ETFs simply can’t keep up and can actually hurt returns. With the number of options growing, there’s no reason not to be active with your commodity portfolio.