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


Inflation series part four-The assessment

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ZPS Inflation Linked Notes Assessment-Part Four

This four part series is designed to aid wealth management firms, pension consultants and family offices with their decision making process within the real return segment.

The series began with an inflation review that included the current state of the market in addition to TIPs characteristics and unique valuation metrics.

We proceeded in piece two to outline the various ways to obtain exposure to inflation linked notes using ETFs as our examples. Then in piece three, we delved into actively managed mutual funds and gave each a score for suitability in a portfolio. Most, including some popular names with massive AUM did not make the cut.

As we wrap up the series with a description and rationale for our favored Zenith Score Fund, we set the stage with inflation rates globally.

Region/country CPI Month end YOY
US 2.13% up May 14
English 1.51% down May 14
European .40% down May 14
German .853% down May 14
Chinese 2.42% down June 14
Australian 2.9% March 14-Next End of July
Brazil 6.374% up June 14
South Africa 6.836% up May 14
France .691% up May 14
Japan 3.71% up May 14
India 7.018% up May 14
Mexico 3.753% up May 14
Iceland 2.238% down May 14
Canada 2.276% up May 14
New Zealand 1.50% April 14-Next end of July

These various inflation rates can help explain in part the differences in performance among the various funds. Since US inflation has been muted until recently, the ETFs such as WIP have outperformed over the last year. This is the ETF we did not recommend for a long term strategic placement and stick to this view despite its out-performance vs funds that focus solely on US TIPs. Our rationale is that the product was in the right place as (non-US) inflation was higher than US inflation in many cases.

WIP, the SPDR DB International Government Inflation-Protected Bond ETF produced a 8.26% return through 7/10/14 while TIP-I-Shares only produced a return of 3.8% largely due to its focus on US TIPS. ILB (Pimco’s active ETF) which has the ability to invest in a variety of global inflation indexed notes produced a 7.04% return.

Rather than choosing between US and non-US inflation, we feel that investors should embrace a manager with a broader opportunity set in order to take advantage of inflation investments on a global scale.

Mentioned above we like the Pimco Global Advantage Inflation Linked Fund (ILB). This fund combines active management within an ETF structure while continually assessing the entire global inflation linked bond opportunity set.

This opportunity set consists of the US, Developed Markets-ex US and emerging markets. Since some of the countries may have small markets, the manager of this fund has a threshold for liquidity and they also maintain a mostly investment grade threshold for inclusion in the portfolio.

It is important to note that their performance enhancers and detractors have a lot to do with the direction of real interest rates. We covered that topic in the first part of this series as the general goal is to garner high real yields and profit from a decline in those yields.

They do a reasonable job of finding value in real yields that are projected to fall and to underweight those that are suspected rise.

The combination of a wider global mandate with active management in a multi-currency portfolio is favorable to us here at Zenith and at least over the last year it is paid off vs at least a few actively managed funds.

We described and scored four funds in the third part of this series. ILB has provided a superior return over the last year in comparison to all of the reasonably mandate constrained funds. American Century, T-Rowe, Vanguard, Fidelity and Pimco all did worse in the open end space than ILB was able to accomplish in the ETF structure.

Within the mutual fund lineup we provided, American Century was the worst while the others struggled to post stellar results as well, again due to their muted mandate and opportunity set.

We highly suggest that your firm examine your inflation indexed notes exposure. Specifically, we recommend that you address the breadth of your managers’ opportunity set and how well they perform within that set.

As part of this vetting process, we encourage your firm to include ILB as one of the top contenders for your inflation indexed note exposure.

If you have any thoughts or questions with regard to this four part series, please reach out and we would be happy to help sort through this nuanced asset class.


Tom Koehler-CIO

Inflation Indexed Notes ETFs Part #2

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Inflation Indexed Notes ETFs Piece #2

In our last piece we described the inflation indexed notes market along with some of its attributes as they relate to the current inflation environment. Despite the somewhat narrow opportunity set in this market for managers to explore, there are numerous products both within the mutual fund and ETF market.

There are three major segments for an investor within this arena; US only TIPS, Global-ex-US and Global inclusive of US TIPS.

US only ETFs are typically passively managed and are either short or long-term in duration. Below we describe two of the largest in terms of AUM.


TIP-I-Share Barclay Tips Fund ETF-$12 Billion AUM-Passive

Country Exposure: US

Zenith insight-While CPI may increase, the duration risk 7.66 (interest rate) is high given the current low state of real interest rates. It will perform largely in line with the overall US inflation notes market but has little ability to manage duration and to be able to monitor expensive or cheap securities.


STPZ-PIMCO 1-5 Year US TIPS Index ETF-$1.3 Billion AUM-Passive

Country Exposure: US

Zenith insight-This has the same US TIPS specific risk as the TIP product as it cannot navigate across maturity or inflation expectations. It does however posses much less duration risk at 2.53. This may be reasonable for a firm that desires US only exposure and less duration risk.


There is also an option to abandon the US TIPS market completely and invest in an ETF that holds non-US global inflation notes although we do not believe this is a prudent move to exclude one of the largest and potentially rewarding TIPS market in the US.


WIP-SPDR DB International Government Inflation-Protected Bond ETF-$976 Million-Passive

Country Exposure UK 20%, France 18%

The remaining country exposure is reasonably evenly weighted.

Zenith Insight-The performance of this ETF is dependent on the performance of two countries that are close to 40% of the fund. The 10 real duration risk as well as the credit quality that is not AAA such as with an all US TIPs fund warrants close examination as this can affect your portfolios overall credit. An investor needs to possess the conviction that UK and France hold potential for a decrease in real interest rates.

It makes more sense to us to look at a US inclusive global fund for those firms that want to gain exposure to the larger inflation indexed note opportunity set. Pimco, given its massive size and budget is able to provide another offering in the ETF TIPS space.


ILB-PIMCO Global Advantage Inflation-Linked Bond Strategy Fund-$139Million-Active

This is an actively-managed exchange-traded fund composed of primarily high-quality inflation-linked bonds that span developed and emerging markets. The fund will normally invest at least 80% of its assets in inflation-linked bonds

Country Representation-US 20%, EU-25%, Brazil 19%, EM 10%

Zenith Insight– This offering does hold appeal. It is actively managed so country exposure will change over time to accommodate varying inflation expectations. It also is a multi-currency fund that can provide additional diversification benefits as well as active exposure to promising inflation markets. Its duration risk is in below that of WIP that stands at 10 and is roughly in line with a US only TIPS ETFs.


This piece was meant to outline the major choices for your investment committee with regard to inflation indexed notes within the ETF sphere. Through examples the basic choices are there for your review. In our next piece we will review actively managed mutual funds to aid in your vetting process.



Tom Koehler-CIO


Inflation Indexed Notes-Piece #1 in 4 part series

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We feel that inflation has a direct and indirect impact on financial and real assets. That effect can arguably be seen the most directly through Inflation Indexed Notes. Here in this brief, we will outline the basics of this asset class as well as the current inflation and real rate environment.

Description, Characteristics and Opportunity Set

  • Government bonds that pay interest and appreciate with the pace of CPI.
  • They have generally been a less volatile way to access inflation protection compared to gold and other metals and resource stocks.
  • There is the opportunity to invest in US TIPS and Global Inflation Indexed Notes in sovereign countries that issue them.
  • The market is less robust and liquid than nominal Treasury Notes.


Unique attributes

Diversification-They have been uncorrelated to risk assets such as equities and also to other debt instruments in the past. However; they are not immune to a decline in value at the same time other risk assets are subdued by market pressure.

Inflation Hedge- They have served as an inflation hedge since their inception due to the direct principal tie to the consumer price index (CPI). Also, as the principal appreciates, the coupon rate is multiplied by the increased amount.

Dual asset class role-They fall into the “real return” and traditional bond categories.

Tax- They are free from state and local taxes.



Since they have a real yield they are partly valued on the difference between that yield and that of a comparable Treasury nominal yield.

  • That difference is the “break even” or what investors expect inflation to be over the life of the bond.
  • If the investor expects inflation to be less than the breakeven rate, then all other factors aside, the nominal bond will be a better investment.
  • If the investor expects inflation to be more than the breakeven rate, then all other factors aside, the inflation linked note will be a better investment.


Current state of inflation and the inflation notes market

  • Real interest rates are now close to zero and set to rise only moderately, according to the IMF.
  • Similarly, the factors influencing rates in past are unlikely to reverse.
  • Ten-year real interest rates across countries fell from an average of 5½ percent in the 1980s to 3½ percent in the 1990s, 2 percent over 2001–08, and 0.33 percent between 2008 and 2012.
  • At least in the next few years, it seems unlikely that central banks will seek to push up real interest rates. As the IMF writes: “In summary, real [interest] rates are expected to rise. However, there are no compelling reasons to believe in a quick return to the average level observed during the mid- 2000s (that is, about 2 percent).”
  • Current 10-year breakeven rate is 2.21%. Expectations are a little higher than actual inflation.


Positive scenarios for TIPS

  • Purchase a high “real yield” and benefit from a decrease in real yields.
  • Inflation will increase the principal amount and the cash flow.


Negative scenario for TIPS

  • Purchase a low “real yield” and lose from an increase in real yields.
  • Deflation will allow the TIPs owner to retain the par value but there will be an opportunity cost with no inflation accruals and the chance to have bought a higher yielding nominal bond.


Global Inflation

American Inflation CPI 1.51 % march 2014
English Inflation CPI 1.67 % march 2014
European Inflation HICP 0.47 % march 2014
German inflation CPI 1.04 % march 2014
Japanese inflation CPI 1.51 %  february 2014
Chinese inflation CPI 2.31 % march 2014


It does not appear that inflation is a major concern presently as these year over year numbers indicate. Inflation indexed notes have generally not been a good performing asset class over the last year as inflation and inflation expectations have been muted in spite of the fear that the Fed’s printing press will eventually create inflation.

In our next piece we will dissect a few ETFs in this space and help determine the potential payoff as well as the inherent risks given this inflation and real rate outlook as well as the country weights within each product.


Tom Koehler, CIO