Lower oil can hurt

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The precipitous decline in oil over the last few months is not news and is really a matter of higher supply with lower demand. Some believe this imbalance will continue for some time. This is up for debate but the market inter connectivity is very much alive and continues to be painful for investors in a number of asset classes.

Brent Crude is down approximately 27% from its June high. While that is seemingly good for consumers, the speed and ferocity is truly a worry as the deflation fears are here and are leaving the Federal Reserve with a tougher time with interest rate policy.

The ETF (XLE) is down over 20% in the same time frame as the large energy producers equity valuations have been hit very hard. They have fared well however vs the smaller energy exploration companies whose balance sheet and credit quality is not as robust.

XOP is the SPDR ETF that represents a large portion of the oil exploration companies and is down from June peak 32%. That is the equity and depending on your high yield bond fund, there may be additional pain. Some of these companies at the lower end of the credit spectrum issued bonds at or near par(1oo centS/$) and are trading in ranges from 55cents to 70 cent on the dollar.

As equity is at risk of losing all value, these bonds can default and leave the investors with little to no residual value. They were sold most likely with optimistic scenarios to warrant the par pricing but reality has set  in.

A broad based investment in commodities has not helped either as they are down close to or over 20% from peak as well.  They say a strong dollar is partly to blame but diversification away from the dollar has been the asset allocation advice for a long time. Now markets are converging against that thesis. It is time to delve in the intricacies of the models.

We suggest that you hold a conference call with each of your managers to determine their risk profile with respect to their positions and how they plan to maneuver this treacherous environment.

As always, we are happy to help with that discussion preparation to aid in the market and manager due diligence.



Tom Koehler, CIO









Commodities….Take a close look at them. ETFS Part three

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Real Return Series ETFs Piece #3

In our introductory piece we outlined the commodity asset class and explain some of the unique characteristics inherent in futures based products specific to commodities.

There are many products available and given the large variance of performance, it is very important to examine the construction methodology and assess the uniqueness of each.

FTGC-First Trust Global Tactical Commodity Fund-Active $183 Million AUM

Futures contract based
Zenith insight-This manager utilizes volatility studies to determine risk and position levels. They actively rebalance at least monthly to mitigate risk and volatility and the composition of the portfolio will change and differ to a large degree from the benchmark.

The benchmark is the Bloomberg Commodity Index and they have beaten it for the short time they have been in existence especially YTD by a wide margin. They have the potential but no guarantee to be able to mitigate contango.

GCC-Greenhaven Continuous Commodity Index-Passive $360 Million AUM

Futures contract based
Zenith insight-This ETF seeks to passively track its index through daily rebalancing to keep the weightings at 1/17 of the portfolio. While there is little active process, the adherence to a different index is refreshing. Typically and early in the game, funds had as their benchmark, the DJ-UBS Commodity Index or the Goldman Sachs energy heavy index.

They manage around the Thompson Reuters Continuous Equal Weighted Index which means that some of the energy heavy bias in other indexes is mitigated as agriculture is increased in percentage in addition to metals. They do not have much ability to mitigate the effects of contango in the portfolio.

GSG-I-Shares GSCI Commodity Index Trust-Passive $1.1Billon AUM

Futures Contract Based
Zenith Insight-This ETF lacks inspiration in a few ways. First, it seeks to track a very energy heavy Goldman Sachs Index and does not offer much in terms of value added tactics. This should be evaluated and replaced with a more dynamic investment.

DBC-Powershares DB Commodity Tracking Fund-Passive $5.6Billion AUM

Futures Contract Based
Zenith Insight
This fund similar to GSG has little appeal in the weighting scheme as the weights are typically going to favor energy and specifically oil. They do however have the structural ability to invest in contracts beyond the near month to help mitigate the effects of contango.

It tracks the DBIQ Optimum Yield Commodity Index which allows for this flexibility. The results have been reasonable and potentially worth a look.

CMDT-I-Shares Commodity Optimized Trust-Passive $13Million AUM

Futures Contract Based
Zenith Insight
This fund was created we feel in part due to its sister product mentioned above that lacks a dynamic method to deal with the effects of contango. It does not possess a unique weighting methodology.

Bloomberg Roll Select Commodity Index is the chosen benchmark that structurally allows for some contango mitigation.

USCI-United States Commodity Index Fund-Passive $646 Million

Futures Contract Based-but allows for non-futures exposure
Zenith Insight
This fund deserves consideration as it utilizes a unique benchmark that is equally weighted and rebalanced on a monthly basis. Regular rebalance mechanisms are important as this is a dynamic asset class.

The benchmark is the SummerHaven Dynamic Commodity Index Total Return℠ (SDCITR) is an index designed to reflect the performance of a portfolio of 14 commodity futures. This ETF deserves attention.

Our goal at this juncture was to familiarize your firm with the various ETF products available with some assessment and directional guidance.

We would like your investment committee to take away a couple major points as you examine your commodity exposure.

a. Contango/Backwardation-Please take the time to examine these two characteristics of futures based products prior to making a placement.
b. Some of these funds are more capable of handling this issue and it is very important to decipher this.
c. Index benchmark selection can have major implications for risk adjusted and absolute performance. As we pointed out, some of these ETFs possess a more dynamic weighting scheme that holds the potential for outperformance.

We will take the time to outline some of the Exchange Traded Notes (ETNS) in our next piece on commodities. This will help drive the decision between ETFs and ETNs for investment committees. It will also help illustrate reasonably obvious examples of funds that should be sold and replaced.

Lastly, with most commodity indexes and products experiencing reasonable to robust performance year to date, this is a VERY good time to examine your holdings in this area.


Tom Koehler-CIO

Commodity Issues


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.


Tom Koehler-CIO

Commodity weakness persists

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Zenith Portfolio Strategies Commodity Update

The first two instruments represent two base metals and their respective futures curves. Contango is defined as far month contracts selling higher than near term contracts. It is generally not an enviable condition. Backwardation is a condition where the far out contracts are less expensive than the near term contracts.

I-Path Dow Jones-UBS Copper Total Return Sub-Index ETN JJC

  • Supply glut
  • The futures curve is mostly in contango
  • Weak technical indicators persist
  • Down 14%  1yr


I-Path Dow Jones-UBS Aluminum Total Return Sub-Index ETN JJU

  • Supply glut
  • The futures curve is mostly in contango
  • Weak technical indicators persist
  • Down over 15% 1 yr

 I-Shares IAU  Gold

  • $ strength
  • The futures curve is in contango
  • Weak technical indicators persist
  • Down approximately 5% 1yr


PowerShares DB Commodity Index Tracking Trust DBC

-The index commodities are light, Sweet Crude Oil (WTI), Heating Oil, RBOB Gasoline, Natural Gas, Brent Crude, Gold, Silver, Aluminum, Zinc, Copper

Grade A, Corn, Wheat, Soybeans, and Sugar.

  • demand and supply dynamics are largely in excess supply but are specific to each commodities unique dynamic
  • The futures curve is mostly in contango although there are portions of each unique commodity that are in backwardation.
  • Weak technical indicators persist
  • Down approximately 5% 1yr


This group represents a mix of equity commodity producers.


SPDR S&P Metals and Mining ETF   XME

  • Weak fundamentals
  • Weak technical indicators-1 yr time frame
  • Sharpe, Treynor and Information Ratio are all negative for a 3yr time frame
  • Standard deviation is 30 for the last 3 yr time frame
  • Down over 17% 1yr



Market Vectors Coal Index ETF KOL

  • Weak fundamentals
  • Weak technical indicators-1 yr time frame
  • Sharpe, Treynor and Information Ratio are all negative for a 3yr time frame
  • Standard deviation is 33 for the last 3 yr time frame
  • Down over 26% 1yr



Market Vectors Rare Earth Strategic Metals ETF

  • Weak fundamentals
  • Weak technical indicators-1 yr time frame
  • Sharpe, Treynor and Information Ratio are not available for the last 3yr time frame
  • Standard deviation is not available for the last 3 yr time frame
  • Down over 34% 1yr


Zenith recommends that wealth management firm investment committees take the time to examine the dynamics of each portion of the commodity complex. While it is not a definitive indicator 100% of the time, a weak commodity complex can be indicative of waning global demand and potentially weak risk assets.

We will update as the base metals complex show signs of fundamental strength in aggregate cash flow and supply demand dynamics become more favorable. Until then, continue to hold near the bottom end of established ranges for commodities.

Fed action and investments

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Zenith talking points for investment committees

QE3 and asset class performance and assessment-The FED and the ECB have created an asset class tailwind in two distinctly different areas. The FED has especially added to this as they announced the purchase of $40 bill/month of agency mortgage backed debt for a long time.

1. Mortgage Backed Debt-

  • Agency Debt-Fannie and Freddie debt will be purchased but the yields are a paltry 1.5%-2.25% depending on the issue.
  • Non-Agency RMBS or private label will not be purchased by the Fed as they do not carry an implicit Government guarantee. The yields range from 5%-6% generally.
  • YTD-These securities have performed well and the performance varies by manager selection. Factors include the amount dedicated to non-agency debt, prime or ALT-A and duration management.
  • Talk to your fund management team to assess their positioning and if it continues to fit your firm’s risk objective.
  • If the fund is too heavily weighed in Agency debt, the return may be low going forward in spite of Fed support.
  • If the fund is taking on a lot of Non-Agency credit risk, there could be potential poor performance if conditions deteriorate in the housing market.

2.  Metals and Miners

  • These stocks have generally performed very well since the QE announcement and include basic materials such as copper and precious metals such as gold.
  • The base metals as represented by the futures based ETFs and funds have also performed well as the inflation expectations from the QE announcement have risen substantially.
  • We advise separating the precious metals from the base metals and material producers as they both have different performance drivers.
  • They have both appreciated in large part due to the QE announcement although sustained global demand will determine the sustainability of the rise in base metals while currency debasement could shape the future of gold.
  • Assess the valuation metrics of your metals and miners funds or ETFs to determine if they continue to look attractive given your firm’s risk objectives.


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Gold Update-

MPT Statistics 3yrs prior through 12/31/12 for–   IAU-I-Shares Gold Trust

Standard Deviation 19.29%- Important for allocation %

Against the Morningstar Long Only Commodity Category

Upside capture 83.09

Downside capture 45.50

Alpha 11.48

These are positive statistics and why we believe it is prudent to separate the precious metals component from broad based indexes, both strategically and tactically.


These are four major factors cited recently by the World Gold Council that lend support to the investment case for gold.

  • Inflation risk
  • Medium-term tail-risk from imbalances
  • Currency debasement and uncertainty
  • Low real rates and emerging market real rate differentials

Zenith’s commentary on each factor

1. Inflation risk-While there is much debate on the true dynamics of inflation, there has not been a massive upsurge in traditionally defined inflation (CPI). This is in spite of a massive quantitative easing campaign by the world’s central banks. In part this is due to the continued decline in the velocity of money in the economy. At least in the US, bank lending is still very slow and in Europe the economy is anemic at best.

Also, it is important to note that gold has not always been correlated with inflation over certain periods of time.

2. The massive imbalances across sovereign balance sheets globally is worrisome especially as countries attempt to balance growth and austerity. Also, credit buildup in risk assets is fostered in large part by artificially low interest rates. While temporarily beneficial, most credit imbalances correct themselves and gold may hedge this risk.

3. The “race to the bottom” continues as monetary authorities continue expansionary monetary policy. Japan’s latest attempt to break free of deflationary forces is just one of many examples of forced currency devaluation.

4. Low real interest rates have been a positive factor for gold. While this should continue, a surge in inflation may prompt central banks to tighten earlier than expected possibly increasing real interest rates depending on the degree of tightening.


Gold holdings for sovereigns as of Sept 2012


Country Tons of Gold held in reserves % of foreign reserves held as gold
US 8133 77.7%
Germany 3396 74%
Italy 2451 70.9%
France 2435 73%
China 1054 2%


Statistics are taken from the IMF and presented by the World Gold Council. While updated in September, there may be numbers that are a couple months old.

We feel that China will continue to purchase gold in order to diversify it’s reserves. At 2%, it has a long way to go in order to approach many developed countries percentages  or to even produce a reasonable hedge against its paper assets.


Third quarter 2012 gold demand statistics


Source of Demand % change in demand in Q3 ’12 from Q3 ’11
Jewelry Demand -2%
Technology -6%
Investment -16%
Official Sector -31%

Third quarter demand was up 10% compared to the second quarter but 11% less than the 3rd quarter a year earlier. The %s in the table are weighted and given the underlying weightings represent an average of -11% decline.

This is not as significant as it appears as 2011 was a record year in many respects for gold purchases. Jewelry demand will ebb and flow mainly with the Indian and Chinese economies while investment demand is partly dependent on a large investor block continuing to believe in inflation potential and central bank balance sheet expansion.

 Bear case


  • Dollar strength-Gold and the $ have traditionally been negatively correlated. The flight to safety and out of European denominated assets has given the dollar a strong boost. As attention may turn to our own fiscal issues, the dollar may not continue appreciating. Also, even if it holds at these levels, there could be a case that institutions that are overweight dollars, may seek to diversify into gold.


  • Emerging market weakness continues-Consumers in India and China are unable to consistently buy gold if their economy slows.


  • Deflation-Since gold is perceived as only an inflation hedge by some investors, a global inflation slowdown with deflation could place pressure on this metal.


Bull Case


  • Deflationary concerns in some countries provide room for further fiscal and monetary stimulus. This may lead to a further debasement of currencies through unconventional monetary policy.
  • The underlying structural issues that affect the euro zone remain unresolved, despite advances in the formation of more comprehensive burden-sharing mechanisms. In such an environment of uncertainty and higher market volatility, gold will continue to be an asset that investors use to diversify risk and preserve capital.
  • Negative interest rates persist in many markets with inflation fears elevated.


We recommend that investment committees examine each factor that supports the case for gold. Determine the factors prevalence going forward and the risk to each one. A full examination would include historical and current correlation trends as well as a closer look at each segment of demand.

Commodity Watch

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Basic Trade analysis for metals, mining and basic materials

On 5/4/12, Zenith put out a post on the FPA(Financial Planning Association) website to garner a discussion with respect to the commodity producers given the European uncertainty and a slowdown in China. At that time we examined and passed on a beaten down investment in the S&P Global Materials ETF (MXI).

On 5/14/12, Zenith put out a post on the FPA website reiterating our disdain for this area of the equity markets as we reviewed all three of the ETFs mentioned below.

Zenith continues to be risk averse especially in the asset classes with the most volatility and ties to global growth. We continue to avoid commodity indexes and are finding little value in the aggregate base materials company stocks.

XME-S&P Metals and Mining


90% Basic Materials

P/E 14.88x and 12.48% EPS Growth

P/CF 7.83x and .87% Cash Flow Growth

P/REV .59x and 7.56% Sales Growth

Book Value Growth 4.48%

MXI-S&P Global Materials

Canada14,UK13, Aus 12, US 23

90% Basic Materials

P/E 11.61x and 9.07% EPS Growth

P/CF 6.76x and -29.91% Cash Flow Growth

P/REV .86x and -30.53% Sales Growth

Book Value Growth 5.36%

IRV-S&P International Materials Sector

90% Basic Materials

Can 22, Aus 18,UK17, Jap 14, Germ 8

P/E 11.56x and 9.82% EPS Growth

P/CF 7.07x and -30.57 Cash Flow Growth

P/REV .8x and -31.6% Sales Growth

Book Value Growth 3.28%

While some of the metrics do appear reasonable sales and cash flow growth are both terrible and there is simply to much uncertainty with regard to Europe and the Chinese “slowdown”.

Each of these instruments is down considerably since we first advised against them and while they may rebound, the climate is too uncertain for a high octane bet. We do not recommend a placement at this time.

The fundamental metrics provided by Schwab

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