WisdomTree highlights benefits of commodity ETFs to portfolio efficiency

Jun 3rd, 2016 | By | Category: Commodities

Including broad commodities in multi-asset portfolios, which are traditionally made up of equities, bonds and cash, could improve their performance profiles, according to research from leading exchange-traded fund provider WisdomTree (Europe). The findings illustrate that investors may reduce the risk and enhance the return of multi-asset portfolios by including a diversified commodity-based ETF.

WisdomTree highlights benefits of commodity ETFs to portfolio efficiency

According to WisdomTree research, combining an enhanced roll commodity strategy with a traditional portfolio of equities, bonds and cash leads to higher expected returns for any level of chosen risk.

By using Markowitz’s mean-variance portfolio theory (see chart below), WisdomTree shows how exposure to such a commodity strategy can improve the performance profile of a multi-asset portfolio comprising global equities, global bonds and cash.

Represented by the orange dots, allocations into global equities, global bonds and cash would have provided investors lower returns for certain levels of risk than if they supplemented this portfolio with some allocation into a broad diversified enhanced commodities strategy, represented here by the enhanced/optimised roll version of Bloomberg’s Broad Commodities Index. As shown by the green dots, for a given level of risk, a higher portfolio return was achieved through some allocation into the diversified, enhanced commodities strategy.

WisdomTree Commodity Portfolio diversification benefits

Source: WisdomTree Europe, Bloomberg. Data based on monthly total returns in USD since May 2001, which is the inception date of the
diversified enhanced commodity strategy.
* 3M US Libor, ** JP Morgan Global Aggregate, *** MSCI All Countries World, **** Bloomberg Optimised Roll Commodities

WisdomTree’s research also shows that to maximise the risk/return profile of the portfolio, investors should select commodity ETFs that provide an enhanced roll strategy. Rolling costs (the loss of value from buying new, more expensive futures contracts when selling contracts close to expiry) can be significant for investors. Futures markets exhibiting higher prices for longer expiry dates are said to be in contango and result in rolling costs to investors.

For example, the oil market crash in the summer and autumn of 2008 has rendered the commodity in contango. From 2009 to end of April 2016, the return on WTI crude oil spot prices was 3%, but investors rolling front month futures would have lost 62% over the same period. Similarly this year, amidst sharply rebounding crude oil prices rising 24%, investors only received 5% due to rolling costs.

The enhanced/optimised roll strategy exploits the upward sloping futures curve. Broadly speaking, when commodity markets are in contango, an enhanced/optimised roll strategy invests in futures contracts further out where the slope of the futures curve is shallower (and where time and rolling erodes futures prices less). As such, investors suffer from less rolling costs than in the case of a conventional roll strategy where investors stay invested in futures contracts nearer to expiry.

One comparison is Bloomberg’s broad commodities index compared to its enhanced/optimised roll version, where the returns to the latter have been – on average – 7.5% higher per year compared to the former.

Commenting on why investors should consider commodities again from a tactical allocation point of view, WisdomTree writes that bond markets are looking increasingly dislocated and prone to downside risk while the equity market recovery since 2009 and the unabated rally since 2015 is looking tired, underpinned in part by slowing growth prospects of tech stocks and the deep balance sheet restructuring of bank stocks.

Against this backdrop, commodities have rebounded strongly this year while still looking depressed against the price trend of the last five years. In the face of slowing but stabilising emerging market growth, a diversified commodities exposure employing an enhanced/optimised roll strategy may complement multi-asset portfolios by giving the investors better diversification and improved returns.

Investors sharing this sentiment may consider the following UCITS ETFs:

The WisdomTree Enhanced Commodity UCITS ETF – USD Acc (WCOA) trades in US dollars or British pounds on the London Stock Exchange. The fund tracks the performance of the Optimised Roll Commodity Total Return Index. As of 29 April 2016, the index has significant exposure to agriculture (34.4%), energy (32.3%), industrial metals (17.0%) and precious metals (16.3%). The total expense ratio of the fund is 0.35%.

Deutsche Asset Management’s DBLCI – OY Balanced UCITS ETF 2C (XBCU) tracks the DBLCI-OY Balanced TR Index. Deutsche Bank selects the futures according to “optimum yield” rules which seek to minimise potential losses and maximise potential gains which arise from replacing futures close to expiry with futures expiring at a later date. The index represents a broad commodity benchmark which includes exposure to WTI Crude Oil, Brent Crude Oil, Heating Oil, RBOB Gasoline, Natural Gas, Gold, Silver, Aluminium, Zinc, Copper, Corn, Wheat, Soybeans and Sugar. The total expense ratio is 0.55%.

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