Welcome to a New “Normal” in Commodities?

Davide Accomazzo
Davide Accomazzo, MBA

The telegraphed day of reckoning has finally arrived and many commodity exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are now finding themselves in the regulatory line of fire.

I have been on the record with my MBA students and with many of my colleagues in the investment business for quite some time regarding the multitude of problems associated with commodity ETFs. Finally, it seems corrective actions are being taken.

Just recently, UNG, the ETF that attempts to track natural gas futures’ performance, was subject to massive price distortions. UNG built a premium into its price versus its net asset value (NAV) of as much as 20% due to large inflows of money, which, ultimately, reflected investors’ bottom fishing. UNG was suddenly unable to expand its position due to an abrupt fear of breaching position limits in the futures pit.

The lesson learned? When an ETF cannot deliver on its strategy because of regulatory fear, the model is pretty much broken.

Deutsche Bank is closing down its leverage long oil ETF due to similar concerns, and its agricultural commodity ETF was stripped of its exemption on speculative limits in the correspondent futures markets. It will also find it more arduous to continue with the same business model.

Since their inception, I have been a great advocate of ETFs in general, but commodity ETFs in particular have always been ridden with issues. From a regulatory point of view, these are hybrid products backed by derivatives but traded like securities, which allows them to escape scrutiny. By using futures to manufacture tracking performance for the equity investor, they are also inherently leveraged while bypassing the leverage restrictions normally applied to equity products (this is an issue not only with commodity-related products but with index ETFs as well).

Practically speaking, commodity ETFs were built on the (wrong) assumption that prices will constantly rise over the long term (i.e. long only products or funds that only invest from the long side) with obvious price distortion ramifications in markets like commodities that are built for hedging purposes. Commodities have really no beta because they are consumable, transformable, and perishable assets (in brief terms, beta is the passive return or risk premium associated with a specific asset class—frankly, I am beginning to think that the concept of beta is one massively flawed idea in every market, but that is material for another post). The idea that equity investors should passively include this asset class in their portfolios was another of Wall Street’s brilliant, self-serving ideas driven by the never-ending search for a way to repackage risk and earn fees. If an equity investor feels the need to incorporate inflation hedging in his or her portfolio, or seeks an edge in overweighting the commodity sector, there are already plenty of viable choices, such as Treasury Inflation Protected Securities (TIPS), commodity stocks, and gold.

Commodity trading is just that—trading, exploitation of anomalies, and price arbitrage. It should always be approached in that way and not as passive allocation. Futures traders, commodity trading advisors (CTAs) and hedgers are the natural players in this game. ETFs? Not so much.

From a strategic perspective, it is reasonable to expect a potential dull period in commodities for quite some time as these ETFs are forced to close or downsize.

Welcome to a new “normal” in commodities?

Related in the GBR

Is Managed Futures an Asset Class? by Davide Accomazzo, MBA, and Michael “Mack” Frankfurter

Examining the Role of Short-Term Correlation in Portfolio Diversification by Jeffry Haber, PhD, and Andrew Braunstein, PhD

The Buffett Approach to Valuing Stocks by Steven R. Ferraro, PhD, CFA

Author of the article
Davide Accomazzo, Adjunct Professor of Finance
Davide Accomazzo, Adjunct Professor of Finance
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