The Big Picture for the Week of July 25, 2010

Businessweek posted a lengthy article called Amber Waves of Pain which is about the extent to which investors are not getting what they expected from commodity based ETFs. Obviously the US Oil Fund (USO) and US Natural Gas (UNG) have gotten the most attention for "not working" but there are more funds that have been impaired by roll issues meaning that the funds have to replace expiring contracts with further contracts that are more expensive--this is known as contango.

The article has all sort of examples of the underlying going up X% while the tracking fund goes down X%. There are many stories like this which is the entire point of the article as a sort of buyer beware.

Slightly bigger picture there are a lot of issues here that have repeated over and over and will do so in the future. I have tried to make the following points before and will do so again.

The general appeal of commodities coming into the last few years was the low correlation to equities. Additionally there are some fundamentals regarding middle class ascendancy an infrastructure build out that stand to put upward price pressure on various food stuffs and natural resources. As investor awareness of this idea grew so too did demand for access to these commodities and as the demand increased so did the prices and this continued for a while as more and more ETPs providing access were built and listed. Demand causing investment product proliferation is an old story--think internet stocks.

The existence of the products creates access for people who would not otherwise have ever had commodities in their portfolio. How many articles have you read that talked about commodities as a new asset class? So it turns out that with this "new" asset class there are a few more moving parts that not everyone took the time to learn about. When USO came out I underestimated the impact of contango in an interview and it turned out to be an issue almost immediately out of the starting gate.

A lot of the article is devoted to John Hyland who is one of the honchos behind USO and UNG. I participated in a lengthy four-way conversation with him where I said almost nothing and neither did anyone else. He also is on TV every now and then talking about why the funds are doing exactly what they are supposed to do. He knows more than you or I do on this subject and has a way of talking where the points he is making are obvious and everyone should know better however, clearly with his funds they do not know better. The end users don't know better, some professionals don't know better, a lot of people do not know better or at least they didn't.

For anyone interested in buying a single commodity it is important to look at a futures chain, which can be done on the exchange websites, to see if a particular commodity is in contango or backwardation. This will impact futures based funds like USO but not the funds backed by precious metals like the various ones for gold and the few for silver, platinum or palladium.

My take all along has been the same which is to maintain exposure but to do so in moderation. The most we've ever had was mid single digits (we targeted a combined 5% at one point with gold and agricultural commodities, sold off some of the ag position at a high price and the rest after something of a drop). Our only exposure of late has been one of the gold ETFs. There have been many articles suggesting 10-20% in commodities which I have always disagreed with. Here there is a repeated behavior at work which is something new comes along and people get very excited, over commit and get blind sided by something they never saw coming. In the time since this site started we've similar things with emerging markets and Canadian trusts and there will be others. Getting blindsided in a 5% exposure is not a financial deathblow, 20% might be.

I do believe in the diversification benefits when looked at over a long period of time. Look at gold for the last ten years versus equities or look at GLD, which is a client holding, since it debuted versus equities. In ten years it is up four or five fold versus a decline for equities. Whatever the reason, when looked at over a long period of time it did deliver. Over the course of a few months anything goes but the context here is longer term.

To repeat from many past posts, moderation is key. Any segment can blow up and if a blow up in some narrow segment would cause you to have an emotional response then you have too much in that narrow segment. Finding out the hard way you have too much is not good but that is exactly what happened to people with these commodity funds.