In investing, the term commodity spans a great deal of assets and sectors. Precious metals, industrial metals, agriculture, livestock, and energy are just some of the varied classes that fall into this diverse arena. In an ideal world of inflationary and deflationary pressures, all of these sectors would move in a similar direction according to cyclical forces.
However, the reality is that significant divergences can appear based on a host of factors for each sub-grouping. Individual influences can include: supply and demand, governmental policy, geopolitical events, weather patterns, and other subtle nuances that affect each commodity differently.
This year, the iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP) got off to a roaring start as precious metals and energy prices went flying out of the gate in the first quarter. However, a subsequent tug-of-war has developed between hard and soft commodities within this aggregate index that has led to a technical breakdown.
DJP is an exchange-traded note that promises to track the return of a basket of liquid commodity futures contracts. This ETN currently has over $1.5 billion invested in gold, crude oil, natural gas, corn, soy beans, gasoline, aluminum, copper, and sugar.
A look at the chart shows an almost perfect bearish head and shoulders pattern that developed over the March-July timeframe. In this instance, diversification actually worked against the maintaining a bullish uptrend as bifurcations among sectors began to develop. So far this year, DJP has gained a modest 2.86% in total return, which lags the majority of traditional stock and bond indices over the same time frame.
Since hitting a high in April, the agricultural sector has continued to deteriorate as corn, wheat, and soybeans hit new year-to-date lows. Prices in many soft commodities have lost traction this year as a result of upbeat supply reports and above-average crop conditions.
The PowerShares DB Agriculture Fund (DBA) has now worsened more than 10% from its 2014 high and is currently trading below its 200-day moving average. Despite finding some recent support, another leg down would likely lead to a re-test of the lows established at the beginning of the year.
On the flip side, we are seeing continued strength in the United States Oil Fund (USO) and PowerShares DB Base Metals Fund (DBB). Geopolitical turmoil and favorable demand trends are continuing to put a bid under crude oil prices, while base metals are finally finding some lasting momentum. USO and DBB have gained 7.87% and 4.98% respectively this year.
Precious metals are another area that has been subject to schizophrenic whip saws in 2014. Both the SPDR Gold Trust ETF (GLD) and iShares Silver Trust (SLV) are trading markedly higher than where they started the year, but have experienced a roller coaster ride of volatility in between. This uncertain price action and lack of clear trend has frustrated many investors.
As an alternative asset class, commodities can be subject to price swings that don’t correlate with traditional stock and bond movement. This makes them attractive to portfolio managers who are interested in fully diversifying across a broad spectrum of investment opportunities. However, it’s also important to understand the pros and cons of each investment vehicle before you make the leap into these markets.
For pure commodity exposure, I prefer to use exchange-traded notes such as DJP over a popular ETF alternative such as the PowerShares DB Commodity Index Tracking Fund (DBC). This is because you avoid the adverse tax consequences of a year-end K-1 as a result of DBC’s limited partnership structure. There are of course limited risks to using ETNs that include monitoring the credit strength of the issuer, as these indexes are backed by the financial institution that issues them.