Take Five with Dave Nadig of Index Universe’s ETF Analytics

Dave Nadig, the president of Index Universe’s ETF Analytics, has closely watched the explosion of the number of exchange-traded products for years.
Exchange-traded funds and notes have allowed retail investors to take advantage of the run-up in commodities prices for the past several years.
He spoke in an interview on the sidelines of the Index Universe Inside Commodities conference in New York Monday about what role these products might play in investors’ portfolios.

InvestmentNews: What is happening in the ETP market with commodities?
Mr. Nadig: I really do feel like we’re in that third wave of commodity ETFs right now, where there’s a lot of breadth and there’s a lot of different ways of attacking different commodities and attacking the contango problem, and now it’s really a matter of what commodities markets investors are finding hot to see which products people are moving into. We certainly saw with GLD [SPDR Gold Shares ETF] — it got tremendous assets on the run-up as gold sort of petered out a little bit — a tremendous amount of money came out of that fund as well.
From my perspective, the ETF story there is that the product functioned perfectly all the way through. It dealt with those huge inflows and outflows without missing a beat.

InvestmentNews: What do you see coming next?
Mr. Nadig: If I look at what’s in filing I think you’ll see more of these sort of contango-beater products. Those contango-beater products are a harder sell so I think they’ll come out and age for a while just like an active-managed mutual fund often will not generate assets for three years until it gets a decent track record under it.
One concern hat a lot of investors had in the past about commodities ETFs was the tax treatment, and what I think we’ve seen is investors getting smarter about that. Currently, if you’re invested in a commodities ETF that’s actually holding futures you get treated as if you actually held the futures. You get mark-to-market at the end of the year, you get 60-40 long term-short term tax treatment and you get a k-1 statement because it’s a partnership. A lot of investors are wary of that and don’t particularly like it so what we’ve seen is a lot more education around the fact that the exchange-traded-note side of the market gets treated like a stock. You get long-term capital gains treatment out of it, which from our perspective is a big advantage to those types of products.
Now, in my opinion, almost all of them are still too expensive. I think at some point we’ll see a price war there. We saw the beginnings of that price war in the gold funds where IAU [iShares Gold ETF] undercut GLD’s pricing by a substantial margin and consequently saw a lot of asset flow. So those kinds of price wars do generate more in assets. There are still few enough players in the space that I don’t expect the price war to be imminent and vicious, but I think you will see pressure on prices downward over time as these products mature.
The democratization of investing is a force built on the back of the Internet, which is not going to go away. It’ll only become easier to trade more obscure instruments. It’ll only become easier to analyze those instruments. ETNs will only get bigger and more liquid over time. ETPs right now are currently about 30% of NYSE trading volume. That’s an enormous part of the financial system, and that’s only going to go up. I don’t see that changing any time soon. We’ll see more assets moving out of mutual funds into ETFs because people like the liquidity and the tax advantages and the transparency of knowing what they own.

InvestmentNews: How will the taper affect how people use these products?
Mr. Nadig: The question really is how much does the interest rate environment impact commodities prices. One of the things I love about the commodities market is that compared to things like interest rates and credits markets or the stock markets, supply and demand is laid bare in commodities. And ultimately the prime driver of commodities prices is going to be supply and demand. Historically collateral yield was the biggest component of being a commodities investor. You would take this levered position in, say, corn, and most of your return came from the fact that you also took the collateral for that position and invested it in Treasuries, and that Treasury yield was this constant tail wind on your investment, and then you could just earn a little extra coming out of corn if you got corn right.
Well obviously collateral yield has effectively been zero for the past five years. So if we actually enter a rising interest rate environment, if the taper actually happens and we actually start seeing yield on short paper at 3% to 4% again, now all of a sudden here’s that tail wind built into commodities. It hasn’t been that way for this entire commodities cycle. That would be good for commodities investors.
But the more speculative the commodity the less it’s impacted by supply and demand.

InvestmentNews: What about gold?
Mr. Nadig: Gold, and for the most part silver, I view as alternative currency, not commodities. Fundamentally, supply and demand in gold are effectively artificial. There’s limited ability to generate supply, which is why it has value at all. So really the main driver of gold prices is always going to be demand. That demand comes from people trying to have alternate stores of wealth, that is largely an investor sentiment issue, so it’s driven by fundamentally different factors than any other commodity you can trade. My opinion is that we see gold effectively range bound until we see significant movement on QE.

InvestmentNews: Do commodities fit into asset allocations differently now?
Mr. Nadig: Absolutely. I’ve seen statistics recently that suggest that commodities allocations are up to 8%, 9% in institutional portfolios. That’s significantly up from 3%, 4%, 5% that that was, say, five, 10 years ago. Now a lot of that allocation has been to gold in that bucket, and I expect that will pare back down. There’s much broader understanding that commodities are a useful part of a normal investors portfolio as well and whereas say 10 years ago if you were talking to a rank-and-file mass-affluent wealth adviser commodities might not have been in the discussion at all. Some of it happened was we had an enormous commodities boom running from 2003 to 2008. It was one of the greatest asset class booms we’ve ever seen. That opened a lot of people’s eyes.

Related Topics: Exchange Traded Notes (ETNs)