Investors are rethinking their commodity allocations after the asset class recorded both the best, and worst performance in the first quarter of 2017.
Money has been pulled from the sector owing to slower growth in China, an unstable oil price and president Trump's failure to deliver on pre-election inflationary rhetoric.
However exchange-traded funds (ETFs) tracking commodity indices saw estimated inflows of $997 million for the week ending June 7 compared to estimated outflows of $458 million in the previous week, according to the Investment Company Institute.
Comeback on cards
An alternatives report from BNY Mellon supported a turnaround, arguing that China's recent reforms, Opec's promised production cuts and the election of Donald Trump 'cemented the final stages of the commodity correction.'
The authors, portfolio manager Robin Wehbe and director and senior research analysts Jason Gibson and Richard Bullock from the Boston Company Asset Management said they were expecting strong compound returns from commodity linked assets.
'We believe the entire [commodities] universe has ample upside as companies are leaner, less leveraged, consolidated and now stabilising due to increasing revenues.'
Despite this, they warned the path forward for the sector will be complicated. Investors should expect cyclical stories to play out, however this should not dampen the longer term secular story.
Performance only half the story
Will Rhind, chief executive of start-up GraniteShares, previously a founding team member at iShares, accepted that some commodity ETFs have seen outflows because the market is down year to date, largely due to lower oil prices.
However on top of this, he said: 'Outside of market performance, we are seeing investors frustrated with high expense ratios and inferior product structures resulting in an unloading of older commodities ETF shares.'
Rhind believes investors are looking to harvest tax losses from legacy commodity ETFs and reallocate investments into lower cost ETFs.
James Butterfill, head of research and investment strategy at ETF Securities, puts recent poor performance down to another factor. He wrote in recent blog post: 'The political worries in the US, with President Trump looking increasingly isolated, and broad tightening of monetary conditions in China has been detrimental to commodity prices, leading to a significant unwinding of exceptionally high speculative positioning.'
According to the Commodity Futures Trading Commission data the sector reached peak bullishness sentiment at the end of February.
2016 marked the slowest expansion of the Chinese economy - which has huge clout when it comes to setting the prices for commodities such as metals - for 26 years.
Talking down the dollar
Rhind added: 'Commodities have historically been used as a hedge against inflation in diversified portfolios. President Trump talked back in April 2017 about the dollar “getting too strong” and indicating preference for lower interest rates. The dollar has been on a downward trend so far this year which is positive for commodities as most commodities are priced in USD.'
Trump's comments however have gone unheeded by the Federal Reserve - it hiked rates by 25 basis points earlier this month, following an identical rise in March this year.
In Europe, ETF provider Source recently launched a commodity ex-agriculture Ucits ETF on Frankfurt-based electronic trading platform Xetra.
The funds claim to give diversified commodity exposure, excluding agriculture and livestock.
Chris Mellor, product specialist at Source, explained European investors have been increasing exposure to commodities this year as commodities represent a broad range of assets.
He said: 'Political uncertainty and high equity valuations mean many investors want to diversify their portfolios.'
Investing in US commodity ETFs
It is important to note there are a number of ways to invest in commodity ETFs in the US Mike Venuto, chief investment officer with Toroso Investments says commodity ETFs can be split into six different categories:
1. Traditional futures roll like USO, DBC.
2. Smart beta futures roll such as GGC.
3. Physical 33 act such as GLD, SLV
4. Hedge commodity ETFs such as GHS
5. Exchange traded notes, more like a bond and unsecured debt note.
6. Leveraged/inverse ETFs provide inverse exposure to popular commodities benchmarks like DDP, DEE.
Venuto said: ‘All of these have merit in certain situations. For example, USO is plagued by contango which makes it terrible as a long term buy and hold position but it has amazing liquidity and delta, making it perfect for tactical short term traders.’
He said with all of these methods investors must consider many difficult to understand factors like UBTI taxes, futures roll and issuer credit risk.
‘At Toroso we tend to use 33 Act physical-backed commodity structures like GLD,’ he said. ‘But we are always looking for smarter versions like GEUR or GLDI, while evaluating the risk of these structures versus the potential rewards of the strategies.’