Commodity ETFs are among the most popular and successful funds in the market today. They are good for hedging and adding to portfolio diversity. Their volatility also makes them attractive to speculators. Sudden price swings are not uncommon. For most investors these ETFs are best used moderately and as part of a larger portfolio strategy.
Commodity ETFs provide direct exposure to precious metals, meats, grains, foods, and energy. These ETFs represent the fundamentals of life. But pricing them is complicated. Commodities are sensitive to any change in supply and demand expectations. Calculation of supply and demand for commodities involves many factors, among them: global growth expectations, inflation expectations, the value of the dollar, interest rates, political events and weather.
This past week has been unusually volatile. The chart below compares the price of an oil ETF, United States Oil (NYSEArca:USO) with precious metals fund PowerShares DB Precious Metals (NYSEArca:DBP), base metals fund PowerShares DB Base Metals ETF (NYSEArca:DBB), and agricultural ETF Powershares DB Agriculture (NYSEArca:DBA). The equity benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY) is also pictured.
The chart above shows that over the past week precious metals (DBP) has been as volatile as oil (USO). Base metals (DBB) and agriculture (DBA) are tracking. The big move in precious metals is a little unusual. Precious metals tend to be less volatile than energy or agriculture.
Typically energy is the most volatile commodity. Volatility ranges from 30% to 50%. The price of oil is volatile because expectations for both demand and supply can change rapidly. Demand for oil hinges on global growth expectations, and growth in emerging markets particularly. These expectations are often revised. Small revisions have big consequences for demand. The supply of oil is also often uncertain. Much of the marketable oil comes from politically or environmentally sensitive areas. Currently few producers have excess capacity and willingness to even out price swings.
Other commodities are typically less volatile. Industrial metals for example have a volatility of 20% to 30%. They are more sensitive to demand expectations than oil but supply is more predictable. Agricultural products typically have a volatility of below 20%. Global demand for food is more stable than energy. Weather impacts supply but agricultural products tend to be geographically diverse and more substitutable than oil. Precious metals are historically the least volatile of the commodity suite. Both supply and demand tend to be stable.
The movement in precious metals and oil shown in the chart above cannot be traced solely to supply and demand issues. The role of speculation in commodity pricing is increasingly important, skewing traditional volatility calculations. Precious metals volatility in particular has increased as the chart above shows. This increase is due in part to the availability of metals brought on by the presence of ETFs that track them.
Speculation is a big part of the recent sell off in both precious metals and oil. Powershares Precious Metals DBP would be more volatile with a different product mix. DBP contains exposure to only two metals, gold (80%) and silver (20%). The chart below compares the price of two ETFs, the SPDR Gold Trust (NYSEArca:GLD) and the iShares Silver Trust (NYSEArca:SLV) which hold gold and silver respectively with the benchmark SPY.
The sell-off in silver over the past week came after speculation helped drive silver up over 100% in the last twelve months. The bull market for silver is accompanied by expanding demand from emerging markets, very low interest rates, and a declining dollar. Emerging markets are growing at high single digits and are increasing their demand for resources. Low interest rates help to drive demand because investors forego less by owning a non-productive asset like gold. The dollar also plays a role. When the dollar is in decline, commodity ETFs are popular as a hedge.
Two factors reversed last week. Emerging markets are having to raise interest rates to contain inflation there, slower global growth outlook overall is forecast. The dollar strengthened. Interest rates in the U.S. remained low.
The effectiveness and low cost of ETFs have helped to make gold, silver and other metals favorites for speculators. Ownership of SLV and GLD involves buying physical possession of these metals. Not all commodity ETFs achieve exposure this way. There is a good reason for this. A bushel of wheat or soybeans, or even a barrel of oil, is more difficult or costly to have physical possession over the long term than a bar of gold. Most commodity ETFs therefore own short-term futures contracts are rolled over monthly to maintain exposure. Others hold longer-term futures and stagger the futures contract months. Finally are also commodities ETNs that seek to track the price of a commodity by the use of a traded note.
Below a list of commodity ETFs and ETNs: