Commodities are not usually the core holdings that investors look to build portfolios around. They are typically after-thoughts that may be purchased for minor diversification benefits, as an inflation hedge, or even as a short-term trading strategy. Yet with the proliferation of exchange-traded funds and increasingly efficient indexes, it’s becoming easier to own a basket of commodity-linked investments.
So, what are commodities? Think hard assets such as gold, silver, oil, gasoline, agriculture products, and industrial metals. Many of the building blocks that the global economy utilizes every day. These assets can be purchased individually or through an exchange-traded fund with the added benefits of transparency and liquidity.
Many investors have abstained from commodity exposure in their portfolios due to the significant deflationary trend that developed from 2013 – 2016. That period created a great deal of excess volatility and non-correlated returns to stock and bonds that made it difficult to justify a position in oil or gold. Fortunately, that trend appears to be finally reversing higher and there are a number of different ways that ETF investors can take advantage of it.
One of the more popular funds in this space is the PowerShares DB Commodity Index Tracking Fund (DBC), which has over $2.4 billion in total assets. DBC tracks a diversified basket of agriculture, energy, and metals sectors through the purchase of direct futures contracts. It’s also one of the longest tenured commodity ETFs with a track record dating back to 2006.
As you can see on the chart, this fund bottomed in 2016 and has been working to develop and sustain a competitive uptrend ever since. The majority of this recent move has been driven by the rise in energy prices, as they make up a significant percentage of the underlying exposure within the portfolio.
Those who wish to invest or track the input products of food and other consumables may be interested in the PowerShares DB Agriculture Fund (DBA). This ETF owns futures contracts in farming industries such as wheat, cattle, sugar, soybeans, and coffee to name a few. DBA has nearly $700 million in total assets and is close to re-capturing its long-term trend line.
One aspect of commodity ETFs that many investors unintentionally overlook are the tax consequences associated with their structure. A fund such as DBC is operated as a partnership rather than a conventional trust. This means that investors are considered limited partners and receive a K-1 at the end of the year for investment activity that does not coincide with gains or losses of their shares. This process is often a headache, especially for those that want to own or trade commodity funds in their taxable accounts.
One way to avoid that conundrum is to purchase an ETF specially designed to avoid it or an exchange-traded note (ETN) that is exempt. For instance, the PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio (PDBC) uses a combination of futures contracts and swaps to accomplish this goal. The fund tracks an indexed basket of 14 liquid commodity contracts, but doesn’t impart the same tax consequences as DBC. It also features a more reasonable net expense ratio of 0.60% compared to 0.89% in DBC.
Another option to consider is the iPath Bloomberg Commodity Index Total Return ETN (DJP). This exchange-traded note is essentially a debt instrument that tracks a specified index. In this case, it’s the Bloomberg Commodity Total Return Index, which counts gold, copper, and crude oil in its top holdings. DJP carries an expense ratio of 0.70% per year.
The Bottom Line
Investors looking for maximum diversification qualities may seek to put a portion of their portfolio in more or more of these funds to broaden their exposure profile. Commodities offer varying return characteristics than stocks, bonds, or cash, which is why they may ultimately help balance risk.
It’s worth pointing out that the index construction qualities of each fund vary significantly. Some put a stronger emphasis on energy, while others focus on higher weights to precious metals or agriculture. Make sure you research thoroughly before purchasing to ensure they meet your investment criteria and won’t adversely impact your tax situation.