This article appears in the April edition of the Financial Post Magazine. Visit the iTunes store to download the iPad edition of this month’s issue.
Take one: Too many stomach-churning fluctuations for most to handle
Commodities offer Canadian investors the chance to add diversity to their portfolios — which usually include a mix of cash, stocks and bonds — because they tend to generate returns on a different basis than the other asset classes. But there are a lot of reasons why the prices of commodities fluctuate: seasonality, global or regional economic growth, supply and demand, the U.S. currency, the weather and geopolitical conflict, among others.
This complex dynamic is tough for investors, especially novice ones, to decode and then properly time. So yes, there is money to be made in commodities, but can mom and dad stomach the ups, downs and unknowns? Hard and soft commodities have been reacting to sluggish growth prospects and slowing demand in China, the world’s largest consumer of commodities, and the surging U.S. dollar. Determining whether these data points will rise or fall at any given time will be a challenge for a retail investor who has little market insight.
For example, a popular trade for professionals and retail investors alike has been calling the bottom in the price of crude. They have jumped into exchange-traded funds that track the movements of oil futures or the stocks of oil producers across North America. Now, these products aren’t always perfectly correlated to the price of crude and, as equity investors know well, there’s more behind the stocks of companies than the price of whatever they produce. Then, there are the costs of managing ongoing positions in futures, which can add up quickly, plus an additional risk if the ETF is leveraged.
There’s complexity within the commodity asset class — and it also shows up in these ETFs, too. The Canadian Crude Oil Index ETF, managed by Auspice Capital Advisors Ltd. in Calgary, has lost about 68% of its value since it began trading in Toronto last May. It’s the first financial contract that is linked to prices of Western Canadian Select, a blend of heavy-grade Alberta crude that has dropped by more than 50% during the period. It looks cheap today, but only because it’s fallen so hard, so fast, and that’s not something mom and pop can generally stomach.
— Christina Pellegrini
Take two: ETFs make it easy for retail investors to add a non-correlated asset class
The term “pure play” gets thrown around frequently in the resource space, but investors looking for this sort of exposure won’t find it unless they have direct commodity holdings. Outside of stashing gold bars under your bed or barrels of crude oil in your garage, commodity exchange-traded funds are the best way to go.
In general, investors have to take into account a number of factors when assessing a commodity. For example, with oil they’ll consider what Saudi Arabia is doing or what technical indicators are suggesting. The most natural option to express this view sends them to the stock market, where they’ll pick their favourite oil producer. “That’s a very dirty way to get crude oil exposure,” says Tim Pickering, president and chief investment officer of Auspice Capital Advisors.
For one thing, that energy company may have financial troubles in the form of high debt, lack of cash flow, few drilling prospects or bad management. Of course, it may be strong in all of those respects, but therein lies the important point investors need to consider: What are they looking for? Commodity-based funds provide investors — both retail and institutional — that pure play, thereby eliminating many of the risks brought by surprises from companies.
Another thing to be wary of is the market beta that commodity stocks bring with them. It’s no secret that moves in the broader market impact equities that don’t have a direct link to what’s going on at the macro level. There is no avoiding that. But when it comes to a commodity-based ETF, such as the Canadian Crude Oil Index ETF, United States Oil Fund ETF or those based on a wide range of other commodities such as gold, there is only one thing that moves the security: the price of the commodity.
Finally, commodity ETFs offer investors much-needed diversification when traded in a tactical and disciplined manner. “You’re really just looking for non-correlation among asset classes,” Pickering says. “By separating commodities from resource equities, you’re making an effort toward doing that.”
— Jonathan Ratner