The search for appropriate alternative assets to be used to diversify investment portfolios has created a demand for ‘financial engineers’ to design and bring to the market a wide range of instruments that are promoted as the tool to use.
Commodity Exchange-Traded-Funds (ETFs) fall into this category. The ease of access to ETFs that are identified by their strategy and transparent portfolios, tend to give a false sense of security in addressing the diversification concern through the use of alternative investment strategies. An ETF may be incorrectly chosen as a proxy to the less accessible managed futures asset class.
Commodity ETFs are beta driven instruments that seek to generate returns solely from the market and minimal dependence on manager skill. This places a commodity ETF into a long-only bias and if the ETF uses futures as the vehicle, further complications will result. Commodity futures are derivatives and have a limited lifespan. An ETF that offers futures contracts under the premise that the underlying asset will rise in value, will be subject to an obstacle that is well known to professionals in the futures industry as contango.
Contango exists in futures markets of underlying assets that are not perishable. Gold and oil are examples of this type of market. This condition exists when the futures price of one of these underlying assets is higher than the price that exists in the cash market. It is confirmed by observing that the series of futures contracts delivery dates that extend into the future, show the greater price in each subsequent futures contract. As the current futures contract approaches expiration and the convergence between the futures and cash markets is observed, the long commodity ETF by mandate of its investment policy statement, will be required to close out the current position and roll into a futures contract with a delivery date further into the future. Contango will erode the returns of the ETF because the contract price of the position that is closed will be lower than the price on the new position that is opened. The spread between these two positions does not exist in the spot markets.
Commodity ETFs that take positions in normal futures markets will be able to profit from the roll over effect. This effect known as 'backwardation', exists when a series of futures contracts have a declining slope of prices. John Maynard Keynes defined this condition as normal. His reasoning was based on the increasing cost of carrying a basket of goods to be held until the progressively later delivery date arrives. Contango is the opposite of backwardation and will occur during times of perceived shortages or sudden increased demand for the underlying assets.
Managed futures programs operated by commodity trading advisors operate under a different set of conditions. These alpha-returns seeking strategies are far more flexible than a long-only approach. A CTA can buy or sell a futures contract on a given commodity with no short tick rule or other restrictions that favour a long-only bias. In addition to this flexibility in directional positioning, a CTA is able to diversify the risk associated with futures trading by entering into several non correlated futures markets. Holding a portfolio of futures contracts in this method both protects the overall equity in the managed account as well as enhances returns. Simply consider taking long positions in both sugar and gold. These two commodities have very little in common and are subject to the influences that affect each one and are not influenced by the same macro influences that are felt in markets such as fixed income and equities.
Proper investment portfolio diversification is clearly done well when the correct set of asset classes and strategies are implemented. It is prudent to understand the workings of the various strategies and the factors that can affect the overall performance. The operational risk of beta designed instruments can create additional risks to the overall portfolio when not recognized.
Trading futures and options involves substantial risk that can lead to loss of capital and is unsuitable for many investors. Past performance is not indicative of future results. Speculate with risk capital only, defined as funds you can afford to lose without adversely affecting your lifestyle. These risks remain present irrespective of whether you hire an outside manager to trade an account.
Jeffrey L. (Jeff) Stouffer is the principal of Mercantile Capital Group, a Herndon VA based introducing broker registered with the CFTC and a member of National Futures Association. He has earned the privilege to use the CFP® and CAIA marks, and holds several FINRA licenses. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. For more details, please visit http://www.examiner.com/investing-in-arlington/commodity-etfs-versus-managed-futures