Stock investors often want to use the commodity markets as a source of diversification. However, often to their peril they opt for convenience over efficiency. This can be a costly mistake.
Commodity ETFs Are Inefficient
On the surface, a commodity ETF such as symbol PowerShares DB Agriculture Fund (DBA) , which tracks 10 commodity futures, seems like a win/win scenario. After all, most people already have an active stock trading account with access to all domestically traded ETFs. Yet, what is convenient is rarely the best solution. Investors of such ETFs are subject to the wastefulness that comes with administrative costs (which often include excesses such as advertising the fund and paid vacations to money managers).
Commodity ETFs are also highly susceptible to contango. Contango is the phenomenon that results in futures contracts with distant expirations trading at higher prices than futures contracts with proximal expirations.
Because of contango, if the value of a commodity stays stagnant, those long the back-month futures contracts will lose money because the price of back-month contracts eventually converges with the cash market price of the commodity. In other words, all else being equal, if a corn futures contract expiring in six months is trading at $4.50 and the front-month contract expiring this week is trading at $4.25, when the December contract expires in six months the price of corn will be $4.25 and a long futures position would be in the hole by 25 cents or $1,250.
Contango is unavoidable, but it is manageable. Those trading the front-month commodity will have less contango exposure than those trading back months. Yet, ETFs generally choose to establish positions in the back months to reduce fund volatility (front-month commodity futures contracts generally see larger price swings than the back months do).
Bloomberg Commodity Index Futures
Most people are unaware but there is an opportunity to trade the commodity complex with a single futures contract: the Bloomberg Commodity Index (BCI) traded on the Chicago Board of Trade division of the Chicago Mercantile Exchange Group using symbol AW (i.e., AWU8 for the September contract).
The index includes 22 commodities with weightings that cannot exceed 15% or fall below 2% for any particular included commodity. Although the contract involves leverage, the margin is low and the pace of profits and losses are manageable.
This particular commodity index futures contract trades between 3,000 and 5,000 contracts per day -- not necessarily ideal, but acceptable. To put the BCI futures contract volume into perspective, the E-mini S&P 500 generally trades a million or more contracts per day. Despite the skimpy trading volume, there are competent market makers present keeping the bid/ask spread tight.
Unfortunately, the volume in this commodity index hasn't increased enough for the exchange to justify listing options (which are convenient for hedging futures positions). Nevertheless, in my view, the Bloomberg Commodity Index futures contract is a great way for investors to gain efficient exposure to the futures markets without much of the hassle. That said, it is necessary to roll the index futures over (exit the expiring contract month and purchase a futures contract with a distant expiration) each quarter.
The Bloomberg Commodity Index futures value is derived by multiplying each point by $100. As a result, each tick in the Bloomberg Commodity Index Futures contract results in a profit or loss of $10 to the trade (i.e.. a move from 89.0 to 89.1). Accordingly, if the index is trading at 89.0, the value of the futures contract is $8,900.
The margin per contract is currently less than $250. Therefore, a trader can speculate in the upside of roughly $9,000 worth of commodities with a "down payment" of merely $250. The same trader could remove the leverage completely by funding the account with the contract value ($8,900 with the index at 89.0).
Risk and Reward Prospects
Commodity market volatility is near all-time lows. Accordingly, it isn't surprising that a broad-based index has been trading sideways in recent years. However, volatility will return, and if it ever does, the upside potential appears to be substantially greater than the downside risk.
For instance, the last commodity route began in 2014 and ended in early 2016. During that time, the BCI fell from the 135.0 area to 75.0 (the lowest value the index has ever seen). Further, the index peaked in 2011 near 170.0, which leaves the current value of 89.0 looking inexpensive.
To put things into perspective, a retest of the lows near 75 would incur a loss of roughly $1,400 but a retest of historical highs would result in a profit of roughly $81,000. Of course, this is a simplistic view. In reality, there are quarterly rollover hassles, transaction costs, contango burdens, and no downside price limits other than zero, but my goal was to portray the big picture.
In my opinion, the Bloomberg Commodity Index is a great way for relatively low stress, hands-off, commodity exposure. Although it would be nice to see the commodity index taper closer to all-time lows before entering, the long-run prospects of being a commodity index bull are attractive.
This column originally appeared May 3 on Real Money Pro, our premium site for active traders and Wall Street professionals. Click here to get great columns like this every trading day.