There are really two major avenues to gain exposure to commodities. Since buying physical commodities such as wheat, oil and copper is not practical, an investor is limited to two choices.

o The companies that produce the commodities
o The futures contracts underlying the commodities

There is a wide range of options with both of these segments and given the complexity of this asset class, it is important to look under the hood of both areas. We will begin with the commodities themselves.

Generally, there are 3-5 main segments that are represented.

o Energy-Oil and natural gas
o Agriculture-Wheat and corn
o Base materials-Copper, steel
o Precious Metals-Gold and Silver
o Soft-sugar and coffee

The weighting of each of these segments and of the individual commodities varies by the manager or passive ETF provider. Remember, all or some of these are represented by a group of futures contracts.

The best example to illustrate a futures contract is that of a farmer who has a soybean crop for instance. Assume in June a farmer expects to harvest at least 10,000 bushels of soybeans during September. By hedging, he can lock in a price for his soybeans in June and protect himself against the possibility of falling prices.

Another example is that of a speculator who believes that oil will rise in price in the future and with limited ability to go and lease an oil tanker, they proceed to buy a futures contract to express this view. It can be profitable; however the magnitude and timing of the rise in price will help determine the gain or loss on this strategy.

In the case of a mutual fund or ETF that needs to have representation across a number of commodities, this entails buying futures contracts as they come due within energy, agriculture, base metals, precious metals and soft commodities. Some “roll” the contracts every 3 months, while others have the flexibility to buy contracts farther out on the calendar. There is no way to completely mitigate the major risk with these commodity futures contracts which is called “roll risk”.

Roll yield is the gain or loss caused by rolling into higher priced or lower priced contracts. A term call Backwardation is where there is a positive roll yield from buying cheaper contracts, meaning that prices are lower as the investor buys contracts to take delivery farther out in the future. Rolling future contracts in this market condition can be profitable as the fund is able to purchase more contracts at lower prices.

The risk is if the market moves into a condition where prices are higher for contracts taking delivery further out. This market condition is called Contango and negatively affects funds with a rolling futures contract strategy. This will cause the contracts to depreciate in value.

Another risk is that the “collateral yield” diminishes as it has in recent years as short term interest rates have very low yields. In the past this collateral that managers have used against the futures contracts helped to boost yield when rates were higher but that portion of the return is low.

Current summary of risks:

• These are very disparate markets from energy to precious metals combined in one broad basket.
• Any and each of these can possess contango which is a value erosion condition.
• Interest rates can remain low dampening collateral yield.
• Traditionally bought as inflation hedges, only some of the broad basket is statistically positively correlated to inflation and if inflation wanes, the broad basket of commodities may come under pressure.
• Commodities have at times been an investment to hedge against dollar weakness and so the investment becomes a currency bet to some degree.
• World supply and demand for the commodity complex is in glut condition lessening the price appreciation potential for the underlying commodity.
• Structure-They can be “grantor trusts”, partnerships(3c1) which can have unique tax issues for your clients.

We at Zenith feel that an investment in a commodities fund with futures as the underlying investment possess characteristics that make a profitable investment very difficult to obtain. The due diligence by their nature is more involved than that for a US equity fund for instance and an investment should not be made unless there is a firm understanding of the product. In later pieces we will choose our “favorite” and our least favorite as well as make a comparison to owning the underlying commodity producers.

Sincerely,

Tom Koehler-CIO

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