Best Year Ever: Commodities Edition

apollochil

By Lara Crigger

2009 may not have been quite the crazy commodities barnburner 2008 was, but it's safe to say that commodities investors did, in general, just fine. And there's little doubt that "commodities investor" is increasingly becoming synonymous with "ETF investor."
By the end of 2009, 924 exchange-traded products had hit the market, with assets under management swelling to $791 billion, up from $539 billion in 2008. Not half bad for a "recovery" year.

But what's really astonishing is the commodity story. Although commodity ETFs still make up less than 10 percent of total ETF assets under management, all told, these funds had a phenomenal year, with assets more than doubling in 2009, from $36.1 billion to $73.7 billion at year end.

Going Long During Contango

From the perspective of cash flows, investors poured $30.1 billion of new cash into commodity products in 2009, up from just $13.3 billion in 2008.

Of course, this is still small potatoes compared with assets in U.S. equities ETFs ($379 billion) or international stock ETFs ($210 billion). But given these funds flows, investors have clearly become increasingly convinced in the value of a commodities allocation.
The sad news is that not all those dollars flowing into commodities ETFs were necessarily well spent.

Many commodity ETFs are futures-based. Some, like natural gas poster boy United States Natural Gas Fund (NYSE Arca: UNG), hold just the front-month contract, while others, like UNG's sister product, the U.S. 12-Month Natural Gas Fund (NYSE Arca: UNL), hold contracts of varying months out up to a year. Regardless of the time frame of the underlying contracts, these funds hold their futures until just before expiration, when they sell the expiring contracts and purchase ones with a further-out delivery date.

In times of backwardation, when the price of a futures contract with a later delivery date is cheaper than the one with an upcoming delivery date, this structure works wonders. Essentially, it's a free lunch: The fund buys the lower-priced next-month contract, sells the higher-priced current contract and pockets the premium.

But 2009 was not a time of backwardation. Almost across the board, most commodities markets were in contango last year, which meant that current-month futures contracts became cheaper than those with delivery dates further away. Thus, every time a futures-based fund rolled over their contracts, it sold low and bought high, chipping away at returns every rollover period.

And yet, as mentioned before, investors continued to plow more money into funds structurally designed to lose money during times of contango. Consider the aforementioned UNG: Although the fund attracted more than $5.59 billion in new net inflows in 2009, it ended the year with only $4.63 billion in assets, all in a year where the price of natural gas ended up close to flat.

In fact, rollover losses hit futures-based commodities ETFs so hard that they tended to lag behind their equities-based counterparts. The PowerShares DB Agriculture ETF (NYSEArca: DBA), for example, returned just 1 percent in 2009. The Van Eck Market Vectors Agribusiness ETF (NYSEArca: MOO), which invests in the stocks of companies in the same sector, rose 59 percent.

Several fund providers attempted to deal with the contango issue by releasing new products and revamping old ones. USCF debuted its 12-month natural gas product, which invested in a "strip" of 12 months' worth of futures contracts, matching the similar strategy of the existing US 12-Month Oil Fund (NYSE Arca: USL). Several products in the PowerShares lineup follow "optimum yield" indexes that eschew front-month contracts in favor of those its algorithm suggest will minimize the effects of contango.

The Top Performers

Frequent readers of HardAssetsInvestor.com shouldn't be surprised to see that the SPDR Gold Trust (NYSE Arca: GLD) was the fastest-growing commodity ETF in 2009, swelling from $17.6 billion in AUM in 2008 to $40.2 billion in 2009. In terms of assets, it was the second-largest ETF overall, and had the highest net inflows of any other ETF, at $13.8 billion. Score one for the gold bugs.

It will be interesting to see how physically backed funds play in the coming year. On the one hand, if the economic recovery strengthens, then investor desire for safe havens may weaken, and so will desire for precious metals funds.

But judging from the first two weeks of the year, that sort of optimism just won't hold water: PALL and PPLT (platinum and palladium funds) debuted to astounding inflows, immediately trading over 300,000 shares a day.

Perhaps the fastest launch of last year, however, was the Market Vectors Junior Gold Miners ETF (NYSE: GDXJ), which launched in November. In just two months, the fund managed to attract $654 million in assets, and an incredible $688 million in inflows in just two months of trading, taking it from zero to the top of the league tables.

In a sense, GDXJ was the right fund at the right time: It launched just as gold was in its spectacular November run-up, when it was making (and breaking) price records nearly every day. You couldn't have engineered better timing for a fund made of gold miner stocks. The question remains, with those highs behind us and gold seeming "toppy," will an equity based play on the shiny yellow metal retain its attraction? So far, traders at least seem to think so: GDXJ has traded nearly 2 million shares a day for most of 2010.

Regulatory Fire Fizzles

But perhaps the most important trend to keep your eyes on in 2010 is one that mostly fell out of public view as 2009 drew to a close: regulation of the energy markets.

Remember when commodities ETFs came under fire from Capitol Hill last summer, where regulators and politicians alike blamed futures-based funds for skewing the energy markets? John Hyland, CIO of US Commodity Funds, even had to head to Capitol Hill and conduct a remedial math course, showing pretty conclusively how his fund at least really couldn't be blamed for the rise in oil:

After those hearings, regulators promised new energy market position limits would roll out as early as last summer, which kick-started several commodities ETNs into rapid-response mode. The iPath Platinum ETN and UNG stopped issuing new shares temporarily, and at least one popular fund, DXO, closed and liquidated its assets altogether. And yet, nothing came.

Although the fire in regulators' bellies has mostly waned, it hasn't disappeared entirely. The CFTC held a public hearing yesterday on the topic. Will anything meaningful ultimately come from the hearing's proposal? And if so, how long will it be before a ruling goes into effect?

That's a crystal ball of the cloudiest kind, I'm afraid. But it could easily be the biggest story of 2010, and it's not even MLK day yet.