Active Versus Passive Styles; Which is Best in the Commodity Space?
Jeff is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Exchange-traded funds or ETFs have come on strong in recent years. As new entrants l are introduced to attract investor capital, issuers of the newer ETFs are looking to add some sizzle to their family to gain market recognition. One asset class that seems to have worked well in this aspect is commodities.
Commodities are a broad label as there are numerous ways to participate in this asset class. Physical assets such as a bushel of grain or a bar of gold can be bought or sold in the appropriate cash market. This makes sense for businesses that operate in this space. However, for the average investor it becomes impractical due to the market knowledge and advantage that market participants have over the average investor.
Futures contract or options on futures contracts make access to these markets on a more standardized basis. These are derivatives that are based on the underlying commodity or asset. The exchanges that operate in this market have established the forum and liquidity for such instruments to be traded. However, there is a distinct advantage in favor of the market participants that understand all the risks, rewards, and operating conditions under which these markets conduct business.
One such participant that helps to bridge this knowledge gap is the Commodity Trading Advisor (CTA). CTAs manage client funds in accordance with a detailed program description outline in the disclosure documents and other account forms. Due to the high degree of regulation involved with industry and market participants; it is best to conduct an investigation into learning more about the risks, rewards, and opportunities in this sector. For our purposes, CTAs are adaptable to profit from these market conditions; rising, falling, and sideways. This group represents that active management style.
One passive strategy is the iPath DJ-UBS Cotton Total Return Sub-Index ETN (NYSEMKT: BAL), which is an exchange-traded note issued by Barclays Bank. What this mouthful means is the Barclays Bank will pay the note holder interest and return the principal at maturity. The interest payment is subject to earnings Barclays captures in cotton and payment is based on tracking an index and its performance. This note is subject to call at the discretion of Barclays. BAL is designed to mimic an unleveraged futures contract, or stated otherwise $100,000 is used to control $100,000 worth of cotton. Aside from the terms and conditions set by Barclays, this note can only profit from constantly rising prices. This long-only passive strategy will not be appropriate in declining or sideways market conditions.
The PowerShares DB Agriculture Fund (NYSEMKT: DBA) offers investors the opportunity to profit in all market conditions. This is a complex instrument and has numerous working parts. First DBA sells its share like any other ETF through the unit creation/redemption process. Then DBA transfer the net capital inflows to a trust that operates as a commodity pool. There is no active e management as this pool makes investment decisions according to the DBIQ Diversified Agriculture Index Excess Return, which in turn is based on a broad basket of commodities such as, corn, soybeans, wheat, cocoa, sugar, and others. Investor returns are found in the share price of the ETF and tracking errors between the ETF and index appear to be minimal.
The Teucrium Corn Fund (NYSEMKT: CORN) is an ETF that is a pure play on corn futures. This is a passive strategy that holds long-only corn futures contracts, of differing expiration dates. CORN holds unleveraged futures contracts using the commodity pool and trust structure. This is a passive strategy the allocation of holding three different futures contract maturity dates is a risk management so as to reduce the effects of backwardation and contango. Such terms were created by the great economist John Maynard Keynes. What these conditions represent is the supply/demand imbalance that is observed in different crop production cycles. In futures trading this can either work for or against the investor. An example of this occurs when a futures contract is about to mature and it is sold for a particular price per unit and the funds received from the sale and then applied to purchase the next contract so as to remain in the market. If the sale price of the expiring contract is less than the purchase price of the next contract, then this difference is a loss attributable to higher demand or weaker supply foreseen in the near future.
As these three ETFs represent the passive strategy and the CTAs represent the active strategy, detailed comparisons between these two approaches is best handled with the assistance of a Series 3 licensed professional. Having such a discussion may prove to be beneficial than entering one of these newly minted ETFs that are promoted as the “easy answer” for investors to enter such markets. These ETFs are presented for discussion purposes and this blog is not making recommendations on these due to the complex structures and risks associated with these vehicles.
Jeffrey L. (Jeff) Stouffer is an Investment Advisor Representative and manages the Alexandria VA office of Kingsview Asset Management. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. He can be reached at jeff.stouffer@kingsviewassetmanagement.com and is available to answer any questions about this combined approach.
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