Commodities and currencies are considered good assets for diversifying a portfolio because they have historically displayed little if any correlation to stocks and bonds. Correlation is the degree to which asset classes move independently of each other. So, based on past performance, these assets move up when stocks move down. It’s important to note that correlations can change over time and that past performance is no indication of future results.
Of course, it's worth noting that people didn't want to invest in commodities just because they were there. During the first decade of the twenty-first century, as ETFs gained a wider audience, there occurred simultaneously a huge bull market in commodities: gold, silver, oil, copper, uranium, water, and many agricultural products. Retail-investor demand to get into commodities was huge, but it was difficult. The most common way to trade commodities and currencies is through the futures and options market. Trading futures, however, is much more complicated than the straightforward way to invest in equities. By creating a familiar structure in which investors could invest in commodities and currencies just like stocks, these exchange-traded products (ETPs) made investing in certain assets easier to understand, more accessible, and cheaper to trade.
Commodities are raw materials—the stuff that companies use to make other things. For the most part these are natural resources, such as gold for jewelry or oil for gasoline, or agricultural products, such as wheat for bread, pork bellies for bacon, and concentrated orange juice for the cartons you find in your local supermarket. Commodities are fungible, which means they're brandless, generic, moveable goods.
The first U.S.-listed commodity-based ETP was the streetTracks Gold Shares, now named the SPDR Gold Shares (symbol: GLD). Sponsored by the World Gold Council and marketed by State Street Global Advisors (the trustee for the SPDR), it launched November 18, 2004, on the New York Stock Exchange. Each share represents one-tenth of an ounce of gold bullion as priced by the London Bullion Market Association (LBMA), the British gold industry's trade association. The iShares Comex Gold Trust (symbol: IAU), the second gold fund, launched January 25, 2005, on the American Stock Exchange. It tracks the price of gold on the New York Commodities Exchange, also known as the Comex.
Together, the two funds were a dramatic breakthrough for the ETF industry. Neither one holds stocks or bonds, nor do they track an index. Each holds hundreds of tons of real gold bricks.
Prior to the gold ETPs, buying gold was difficult for retail investors. They had the choice of buying gold coins or gold bricks. Brokers in these products charged steep commissions. Because these are physical commodities, upon taking possession, an investor would need to pay for storage and insurance. If the investor didn't want to take possession, he would invest in the futures and options markets.
Because the process and commissions are onerous, many investors used the shares of gold-mining companies as a proxy for the price of gold. By trading on the stock market, these investments were easier to buy and liquidate. But, gold-company stocks come with their own issues. Because you are first and foremost buying shares in a company, you place at least two layers of risk—stock market exposure and single-company risk—on top of the risk from exposure to the gold market.
The gold ETPs changed all that. Because the shares of these ETPs list on the stock exchange, average investors now have a hassle-free way to own the precious metals without opening a futures account or hoarding bars in a vault.
In April 2006, the iShares Silver Trust (symbol: SLV) debuted on the American Stock Exchange. Like the gold ETPs, the silver ETP is a grantor trust that holds actual silver in a vault. Silver's expense ratio is 0.5 percent.
Silver is a much more volatile commodity than gold. However, it has little historical correlation to stocks or bonds. It does have a 0.66 correlation to the price of gold.
People who don't want to deal with an ETP that holds the actual commodity and has to pay storage costs can invest in gold and silver through the futures market. In 2007, a PowerShares-Deutsche Bank partnership issued pure plays on the gold and silver markets with ETPs that track an index of futures contracts. The PowerShares DB Gold (symbol: DGL) is a pure play tracking an index of gold futures. Also a pure play is the PowerShares DB Silver Fund (symbol: DBS), which tracks an index of silver futures.
Like the precious metals ETPs, USO is a pure play on the oil market. The big difference is that unlike the precious metals ETPs, U.S. Oil doesn't own the physical commodity. It tracks the price of oil through futures contracts. U.S. Oil's structure is different from the precious metals ETPs, which are grantor trusts. U.S. Oil is structured as a limited partnership called a commodity pool. The commodity pool collects money from many investors to invest in a portfolio, usually comprised of futures contracts. Because a commodity pool trades commodity futures, it needs to register with the National Futures Association and agree to be regulated by the Commodity Futures Trading Commission, or CFTC. In addition, because the ETP sells a security traded on an exchange, and issued in a public offering, it also registers its shares under the 1933 Act and is regulated by the SEC.
The NAV for the U.S. Oil Fund is determined by the performance of its portfolio holdings, a basket of futures contracts for light sweet crude oil, and other oil-related securities that trade on the New York Mercantile Exchange. One big advantage in buying a futures contract is that taking delivery of oil is a much bigger headache than gold or silver. This eliminates transportation, storage or insurance costs. They are priced into the contract.
Currencies can be very volatile. The same factors that affect the price of gold affect a currency's value. While war and times of crisis can cause major moves in a currency, all manner of macroeconomic factors, such as trade deficits or interest rates, are also very influential.
Currency ETPs come in two varieties: the kind that holds the actual foreign currency and those that track currencies through futures contracts. Again, the tax structures are different from ETFs and must be examined before buying the shares.
Like the gold and silver shares, the currency ETPs that hold the actual currency are grantor trusts. Unlike ETFs, they don't have any diversification. They are pure plays. The ETPs give currency exposure to a single currency and allow the shareholder to participate in the movement of that currency relative to the dollar. For more diversification, some ETPs track indexes of a basket of currency futures from different countries.
There are many other alternative investments that an investor can now consider as part of their portfolio through exchange-traded products, such as futures, other commodities like grain, currency notes, and more in development every year.
When all is said and done, any alternative investment ETPs that hold a single asset are speculative plays. They can switch direction on a dime and make huge moves on unexpected macroeconomic news. Of course, because these ETPs can be shorted like ETFs, it's possible to invest in either direction.
Instead of buying an ETP tracking a single asset, the best move for individual investors may be to buy an ETP that tracks an index of alternative assets. They give exposure to assets with little correlation to the stock market, but minimize risk by adding diversification.
The most obvious risk to ETPs that track alternative assets is market risk. Market risk includes any economic or political variable that can affect the value, or supply and demand, of the particular asset your ETP holds. However, there are some risks particular to these investments. For instance, shares in the gold and silver ETPs can’t be redeemed for the precious metals they follow, only cash. Also, gold and silver don’t produce income. Thus, the managers for the ETPs must sell some metal to cover expenses. This means there may be a discrepancy between the value of the ETP shares and the value of the underlying assets.
Investors need to be aware that ETPs that hold commodity futures, swaps, or track a futures-based index, don’t hold assets like true ETFs, but rather derivatives. Futures are bets on the direction the price of a commodity may move. They are not backed by actual physical commodities; however, like the physical commodity ETFs, these products can only be redeemed for cash.
Investors need to be clear that futures-based ETPs don’t track the spot price of a commodity, the price you can buy it for today. The value of a share of a futures-based ETP tracking crude oil won’t equal the price of a barrel of crude. Instead, the share’s value will be determined by its following the movement of an index tracking futures contracts or a particular future. The price of the nearest month’s futures contract, called the front month, is usually close to the spot price. But, any factor that causes prices to rise could send the futures price much higher than the spot price of the same commodity. Some ETPs have experienced huge discrepancies between their share price and the spot price of the commodity.
Investors need to be aware that comparing futures ETPs to equity ETFs is like comparing apples to oranges. For instance, to stay invested in equities one just buys stock and holds onto it. But futures expire. Futures contracts need to be rolled into the futures. To stay invested, the fund needs to sell or swap the expiring contract and buy the next one. This adds transaction fees on top of the annual fee paid to management. Frequently there’s a difference between the trading price of the new futures contract and the one that expires. This rolling of contracts can create conditions known as backwardation and contango.
In backwardation, supply is tight and demand is greater today than for delivery next month. Since everyone wants oil today, today’s price is higher than the future’s. In contango, today’s supply is fine, but future supply is in doubt. So, the demand for oil in the future is greater than today’s demand, meaning higher prices in the future. And heavy contango can be an indication that the market is considered oversupplied, making today’s spot price cheaper. Contango eats into returns, while backwardation could potentially help returns.
Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.
Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors which may include changes in national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, and global or regional political, regulatory, economic or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.