Commodities: Go Long and Physical
Source: Dian L. Chu, Seeking Alpha (6/3/10)
Commodities will continue to struggle as the dollar strengthens.
Bears Gripping Commodity
Right now, due to the sluggish growth in industrialized nations, China remains the single largest consumer and buyer of many commodities.
Although China's long term growth prospect remains strong, Beijing has started monetary tightening measures, amid concern of asset bubbles and inflation. The latest PMI data also suggests China's economy could be slowing down.
Furthermore, with the euro and European Union saddled by PIIGS, the dollar could continue to strengthen against euro in the near to medium term amid global risk aversion. Since most commodities are priced in dollars, a stronger dollar typically would depress the price and returns of commodities.
The current momentum of key commodities, including oil, copper and gold, should be moving higher. This will happen as soon as investors feel less nervous about the Greek and European drama, and with the euro gaining support from four major central banks today, and signals of continuing easy monetary policy around the world.
The Gulf oil spill seems to be another event which the markets are having anxieties over. It is true that the Gulf oil spill disaster does have an economic and environmental impact on the U.S. Gulf coast, but in the global scheme of things, this most likely will not cause significant enough impact to the fundamentals of crude oil or economic direction to warrant a full blown commodity bear market.
Instead, this recent pullback on commodities from the market's mis-reaction should serve as a good entry point for long-term investors, and I will discuss a few options in the following sections.
Long term investors looking for exposure to the spot market prices for potential better returns, could look for an ETF fund that takes physical possession of the underlying commodity. But unfortunately, these are presently limited to precious metals funds in the ETF category. (See Table)
Beware of Futures-Based ETF
Commodities, with a historic track record of uncorrelated returns to other markets, can play a role in a longer-term balanced asset allocation. ETFs have made this asset class accessible to the masses. However, many commodity ETFs are based on futures contracts.
Since futures prices differ from spot prices due to a number of factors including storage costs, and seasonal demand pattern, the returns of futures-based ETFs generally differ from the spot price movements of the underlying commodity or basket of commodities. (Chart 2)
Contango Saps Futures ETFs
Lately, many commodity ETFs returns have been sapped by futures markets that are mostly in contango (Chart 2), with near-term contracts trading at a discount to those maturing at later dates. Investors in futures-based commodity funds, particularly shorter-dated ones like UNG, typically pay a premium as contracts expire and roll.
That predicament will only ease when markets flip into backwardation—t hat is when worries about current supplies worsen, which seems an unlikely scenario based on recent economic data.
Hard Assets Producers
Instead of subjecting to the impact of contango on certain ETFs, investors may also take a look at equities of commodity-intensive companies as an alternative, since the profitability of hard asset producers is often tied to the underlying prices of the related commodities.
Commodity Mutual Funds
Depending on the portfolio makeup, and preference, metal funds and ETFs are two fund families with different characteristics that may suit the different investment objectives.
More seasoned investors with appropriate risk tolerance may look into longer-dated futures contracts with stop loss as another way to play in the commodity sector. This strategy could also help augment the futures-based ETFs in your portfolio.