Commodities funds may offer inflation hedge, but many overweight energy

Also, with the exception of some metals funds, most funds don't own the actual commodity.

If you look in the average investor’s closet of anxieties, inflation is probably the biggest, scariest monster of them all. And increasingly, investors have been looking at commodities funds as a way to offset the effects of inflation and diversify their portfolios.

If you’re considering adding a commodity fund to a client’s portfolio, you have your work cut out for you.

“The biggest problem is that there’s no real agreement as to what a commodity fund should look like, and that’s a real problem,” said Dave Nadig, director of exchange-traded funds at FactSet Research.

Inflation is normally a late-cycle economic terror. As the economy heats up, consumer demand increases, factories can’t keep up with demand and the price of raw materials begins to rise. Typically, this happens when unemployment is low and gross domestic product is rising: There’s too much money chasing too few goods and services. It’s at this point that the Federal Reserve starts to raise interest rates, sending inflation scurrying back to its lair.

But many of the diversified commodity ETFs are more energy-heavy than a Bakken shale refinery. Consider the $2.4 billion PowerShares DB Commodity Index Tracking Fund (DBC). The fund has a 12.38% stake in Brent crude oil, heating oil, RBOB gasoline and West Texas Intermediate crude, with an additional 5.5% in ICE natural gas. Total energy: 55.02%, which the company says is now 51.91%. The fund isn’t alone: The $904 million iShares S&P GSCI Commodity Indexed Trust (GSG) has 57.31% allocation to energy.

One exception: The iPath Bloomberg Commodity Index Total Return ETN (DJP) caps exposure to any one sector at 33%, which puts its energy exposure to about half that of the PowerShares offering. “I think the thing that people need to take away is that they have to go web site by web site and suss out the individual differences in commodity funds,” Mr. Nadig said.

And as long as you’re there, you should take a hard look at the fund’s structures. With the exception of some metals funds, most funds don’t own the actual commodity, in part because it’s impractical to store 127 metric tons of corn. Instead, they use a relatively small amount of futures contracts and invest the rest in money-market securities.

Typically, this means buying the futures contract closest to expiration and rolling it into the next contract as the expiration date draws near. If that next contract is higher than the spot price, managers will have to pay up to buy that contract — a situation called contango. In effect, this detracts from performance. A few funds, such as PowerShares DB Optimum Yield Diversified Commodity Strategy Portfolio (PDBC) actively try to reduce the problems of contango.

Another problem: Many commodities funds are exchange-traded notes, which tend to track their indexes well, but are also the unsecured obligations of major banks. And one of the biggest creators of ETNs is Deutsche Bank, which is either a contrarian’s dream investment or, well, a mess.

One interesting approach is FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR), which invests in stocks of upstream raw materials producers. (“Upstream” refers to those companies that find and extract raw materials, rather than the downstream companies that turn raw materials into other things, such as gasoline and Legos.) “We felt there was an uncertain future for using futures in funds because of the current regulatory environment,” said Mark Carlson, senior investment strategist for fixed income and natural resources strategies for FlexShares.

The advantage of natural resources stocks is that they’re sensitive to movements in commodity prices, as an investor in Exxon (XOM) or (more recently), Barrick Gold (ABX) could tell you. Should there be a classic rise in raw materials prices, the stocks of these companies should reflect it.

The question with all commodity-related funds is how effective a cushion they will be in a stock downturn. The historical evidence seems to say “not much.” A 2013 paper by Geetesh Bhardwaj and Adam Dunsby of SummerHaven Investment Management looked at 50 years of correlations between stocks and commodities. Over long periods, the correlation between stocks and commodities is virtually zero, the paper found. That’s a good thing for portfolio management.

Naturally, there’s a sheen of oil on this particular drink, and it’s this: The correlation between stocks and commodities rises in periods of economic weakness. This makes sense: In an economic downturn, demand falls, as does the demand for raw materials. And in a recession, investors become increasingly risk averse, meaning they’re not as likely to flood into the commodities market.

At the moment, at least, inflation remains firmly in the closet of anxieties . The consumer price index including food and energy has gained just 1.5% over the 12 months ended September. But the flood of money from central banks has raised the fear of renewed inflation — and sometimes, just the fear of inflation is enough to make an inflation hedge a good investment.