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How to play commodities (and not get trampled) Add to ...

With headlines about wheat hitting two-year highs and gold on yet another winning streak, investors may be wondering whether commodities should play a larger role in their portfolio, and how best to achieve it.

For years, the primary way to get commodity exposure was through futures contracts, an agreement to buy or sell a commodity at a set price some time in the future. Of course, individual investors don't have the ability to store meaningful quantities of cattle or oil. Hopping in and out of contracts before the delivery date, and dealing with margin calls in a volatile pricing environment can also be expensive hassles.

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The creation of commodity-based exchange-traded funds made it a lot easier for the individual investor. But pitfalls exist there, as well, because of a futures-market phenomenon known as "contango," when the price of a futures contract exceeds the spot price of a commodity.

Exchange-traded funds that rely on futures contracts can fall victim to a problem in this scenario - as they roll over contracts, sometimes as frequently as monthly, they have to pay more for the next contract than they would have to pay for the underlying commodity - that cost leaves investors with more meagre returns than by owning the commodity itself.

In periods of greater contango, the deviation from the return of the fund and the performance of the underlying commodity can be great. In a recent article on the perils of commodity ETF investing, Bloomberg BusinessWeek cited the example of the U.S. Oil Fund, an ETF designed to track the price of light, sweet crude, that fell 7.4 per cent in February, 2009, even as crude rose 7.4 per cent.

There are ways, however, for an investor to avoid this sort of problem. One, notes John De Goey of Burgeonvest-Bick Securities, is to look for ETFs that actually hold the underlying commodities. Since they don't have to roll over into another contract at points of high contango, they minimize that cost while adding to performance.

Examples, Mr. De Goey said, include the Claymore Natural Gas Commodity ETF and the Claymore Gold Bullion ETF. Investors should look in the ETF's prospectus for its mandate to find out whether it intends to own the underlying asset.

Another option is to find ETFs that use longer-term contracts and therefore have less rollover expense. Horizons BetaPro Winter-Term Nymex Crude Oil ETF uses a one-year futures contract as its underlying investment, taking advantage of a futures curve that's not unlike an interest-rate yield curve.

"The deepest part of contango is in the near month, and it flattens out in a year or so," said Howard Atkinson, the president of Horizons Exchange Traded Funds. "It escapes a lot of the effects of contango."

Currently, there's a $3.93 (U.S.) difference between the December 2010 and December 2011 contracts for Winter-Term Crude Oil, Horizons says. Since the contract rolls over just once a year, the monthly equivalent expense is 32.75 cents.

Another school of thought, however, is that investors can avoid futures-contract issues altogether by focusing on equities.

"In most cases, the best way for an investor to participate in commodities is an equity with an exposure to the commodity," said Prakash Hariharan, who manages an agricultural fund for Front Street Capital.

Mr. Hariharan is bullish, long-term, on agricultural commodities, and it's led him to stocks such as Agrium, Viterra and Potash Corp. of Saskatchewan. While the correlation is not 100 per cent by any means, "Movement in these commodities is typically followed by higher applications of fertilizer and higher profit margins in grain handling," he said.

That, of course, adds operational risk to the equation. Newmont Mining is an example of a gold company whose stock didn't track its commodity's rebound because of concerns about its cost structure.

Rather than pick out individual names, then, investors may combine approaches and look at ETFs that hold equities of commodity-linked companies. Many of the choices are broad-based, such as the iShares CDN Materials Sector Index Fund, designed to track the S&P/TSX Capped Materials Index. It lists Barrick Gold Corp. and Potash Corp. as its two largest holdings.

To return to the beginning, however, it would be irresponsible to not point this out: If wheat's recent remarkable run, prompted in large part by Russia's export ban, is prompting the interest in commodities, it's worth asking whether you're getting in at the wrong time.

"The question with respect to wheat or any other commodity is, is this speculation or a fundamental driver, and I don't see this as a fundamental driver," said David Chellew, Mr. De Goey's colleague at Burgeonvest-Bick. "Are we speculating, or are we investing? If we're investing, I'm not buying wheat right now."

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