Investors have been tripping over themselves this year to show love for exchange-traded funds. The U.S. ETF industry continues to grow at a torrid pace, on track to attract $1 trillion in new assets under management in 2021.
However, left out in the cold this year—and pretty much since they came to market 15 years ago—are commodity ETFs. If you omit gold ETF assets from the picture, this is a forlorn group of ETFs chasing scarce dollars.
Even with the yellow metal investments, the picture for commodity ETFs in 2021 stands in stark contrast to the rest of the ETF industry.
It’s the only major assets class not seeing new money roll in; instead, it’s clinging to what it’s got.
Despite commodities’ proven value as a portfolio diversifier and hedge, ETF users have ignored the asset class, relegating it to the corner of the ETF party.
Getting them back into the party is both simple and complex, like a math formula.
Futures & Physical Split
Commodities are easy to understand. They are hard, tangible assets. They are things we eat, build with and mine for. Supply and demand forces dictate their prices clear as day, too. Disrupt the oil supply or production, and oil prices go up. If bad weather kills the corn crop in the Midwest, corn prices are going to go up. Simple.
But trading futures and options is a different animal from owning physical commodities. For one, the pricing mechanism for these derivatives is more complex than basic supply and demand dynamics. It’s futures curves, backwardation, contango, daily resets … it requires math.
Consequently, we see the lion’s share of commodity ETFs assets gravitate to physically backed ETFs. Price action is simple, at least on the surface, to the average investor.
The major problem is you can’t have a physically backed oil ETF without owning Cushing, Oklahoma, and a physically backed corn ETF would require corn to be stored somewhere in possibly hundreds of silos. “Physically backed” means just that—each share of the ETF is backed by the physical commodity stored somewhere.
Contango & Backwardation Are Hard
This practical hurdle to physically backed ETFs prevents the structure from being adopted widely across the commodity space. So, what’s the answer to expanding the ETF reach into this asset class?
I posed this ETF dilemma to John Hyland, one of the world’s foremost experts on commodity ETFs. During his tenure as CIO of US Commodity Funds, he oversaw the creation and launch of oil ETFs in the U.S.—the $3 billion United States Oil Fund LP (USO), and the first and largest natural gas ETF, the United States Natural Gas Fund LP (UNG) in addition to first gasoline, heating oil and copper ETFs.
He saw the budding days of commodity ETFs 15 years ago, and is still watching the segment today. He’s quick to note that much hasn’t changed. In fact, peeling away the assets layer, he leaves you with a bleak core.
Physical Attracts Assets
“The 33 precious metals ETFs, almost all of which are physically based, hold $123 billion [in assets], which is 84% of the total commodity ETF universe,” he said. “The other 77 ETFs split the remaining $23 billion. You could argue that investors like commodities just fine if they are physically based.”
“Even with the remaining $23 billion, we end up with the bulk of those assets, $14 billion—which is 60% of the nonprecious metal AUM—spread out over 22 ETFs that are broad-market baskets,” Hyland explained. “By definition, broad-basket ETFs are going to be used primarily by asset allocators, not traders, and likely not by young investors.”
“So, now we are down to all other commodity ETFs, other than precious metals and broad baskets, sharing a modest $9 billion,” he added. “But wait, it gets still worse. USO and the rest of the oil ETFs hold almost 60% of the $9 billion. So, we are down to 36 ETFs tracking agriculture, soft commodities, industrial metals and energy other than crude oil, sharing less than $4 billion. Ouch!”
Further refining his point, the math is hard, and so are the words “contango” and “backwardation,” which can’t even be found in the Webster’s Dictionary.
“Investors who think nothing about jumping onto complex concepts—which they may or may not truly understand, like cryptocurrencies or blockchain technology—struggle with futures-based products where you have to deal with contango and backwardation,” Hyland noted.
Retail Investors Not Feeling The Love
“You cannot just 'HOLD' an oil or copper ETF for years knowing that when it goes up you will reap that return,” he added. “And even though backwardation helps investors just as contango hurts them—and you always know if a market is in backwardation or contango—retail investors don't seem to care about the topic.”
Unfortunately, the headline “Oil In Backwardation” doesn’t scream opportunity to the retail crowd like “Bitcoin Jumps Higher,” and of course, that’s too bad. If you could match a commodity to its spot price, that’s the ticket.
“Put another way, if you could track the spot price of crude oil, copper or soybeans via an ETF, I think plenty of people would trade those ETFs. But you can’t,” Hyland said. “As a result, most money goes to products where contango and backwardation don’t exist. That is precious metals.
“Another thing to consider is this: We’ve been through an unusual period of low inflation for a dozen or more years. Gold, silver, platinum, crude oil, a bunch of the ags, they’ve all been mostly moving sideways for a dozen years. Sure, you get some spikes and troughs in prices, but there isn’t a long-term upward trendline. Unless investors are seeing signs of a ‘commodity super-cycle,’ there’s just not enough happening in the space to get their pulses racing.
“The quick answer is more investor education, but you can only lead a horse to water. Do I think commodities are a bad fit for ETFs? No, not really. I think it’s mostly that owning commodities over the last dozen years has been uninteresting, so investors look elsewhere. We all know many investors—to their detriment—tend to focus on what just happened, not what’s going to happen. The ghost of past performance is really hard to shake.”
The ETF is a great vehicle, but it may not be the vehicle for everything. Despite all its advantages and nifty quirks, the world of commodities has been a tough nut for the ETF industry to crack. That's OK. Stay away from what you don't understand.
20 Largest Commodity ETFs
Drew Voros can be reached at [email protected]