Commodities have had a heck of a year so far. Between investor optimism over the reopening economy, the infrastructure bill taking shape in Congress, and persistent fears of inflation, the tailwinds for commodities haven’t been this strong in almost a decade.
But the asset class still has plenty of room left to grow, says Kathy Kriskey, product strategist for Invesco’s Commodities and Alternatives family of ETFs.
Kriskey recently joined Invesco with over 20 years of experience in commodity markets. Prior to joining Invesco, she initiated the Commodity Investor Businesses at UBS, CIBC, and RBC. She also managed Commodity Sales at Bankers Trust in London, New York, and Houston and at JP Morgan in New York.
Recently, we sat down with Kriskey to get her take on the commodities space, including the market’s current supply/demand fundamentals, how product structure impacts returns, and her expectations for inflation going forward.
Lara Crigger, Managing Editor, ETF Trends: Could you share with our readers a little bit about your background in commodities?
Kathy Kriskey, Product Strategist for Commodities and Alternatives ETFs, Invesco: I’ve been in commodities for over 20 years, and it is an asset class that can sometimes be challenging. There are good times and bad times for commodities. But I’ve stayed in throughout.
When I started, this business used to be mostly producer/consumer hedging of the commodities. Now, people can invest directly in commodity products, rather than in commodity equities, which is still relatively new. It really only started to develop in 2005. Back then, there were two main benchmarks. The names have changed slightly, but they are now the S&P GSCI Total Return Index and the Bloomberg Commodity Index.
I was very lucky to work at some great places and with some of the key people that helped to create this industry. It’s been quite a ride!
Now I’m the product strategist for commodities and alternatives for Invesco. And it’s been an exciting time to start, even just in the past few months.
Crigger: Flows into commodities products are picking up again, for sure. It’s like 2005 all over again.
Kriskey: Commodities are already seeing a lot of upside potential. The two main benchmarks I previously mentioned, they’re sort of the first generation of commodity products. The DBIQ Optimum Yield Diversified Commodity Index Excess Return [Author’s Note: which underlies the Invesco DB Commodity Index Tracking Fund (DBC) and the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC)] is the second generation.
Crigger: How do you mean?
Kriskey: Well, one of the things that really frustrated commodity investors for many years is this concept of negative roll yield. If you buy an equity index, the hedge for that index is to buy those underlying stocks, right? It’s very simple; it’s very static. But in the commodity world, you can’t do that. You have to buy commodity futures to hedge the commodity index.
Typically, commodity futures indices reference that front month contract: So, when people say the price of crude oil is $65/barrel, they’re usually referring to the front month West Texas Intermediate (WTI) futures contract, and that’s what these historical commodities products would buy. But every month, these contracts expire. You have to “roll” these indices. Meaning, at the beginning of the month, they will move into the next month’s futures contract.
I had a client many years ago in 2005 who said “Kathy, I don’t want to roll.” I said: “Okay, so tell me where we’re sending these physical commodities. Do you have a really big backyard pool for your crude oil?” That concept of rolling really was not familiar to people then.
Ultimately, the slope of these futures curves can really affect the performance of a commodity index.
Crigger: This gets into backwardation and contango and all those other arcane-sounding words that make investors’ eyes go cross-eyed.
Kriskey: Backwardation simply means that the front month price is higher than the next month’s price. When these indices were first created many years ago, a lot of these markets were in backwardation; so as you sold that front month contract and bought the cheaper [farther out]contract, you’d have positive roll yield. Selling high, buying low. That was great. It was an extra little bonus.
But when the market shifted to contango, things really changed. Contango is the opposite [condition], where the market for that front month price is lower than the next [month’s] price. Now, as you can imagine, you’re selling low and buying higher.
Crigger: But what exactly do backwardation and contango signal in terms of commodities market fundamentals?
Kriskey: When a commodity market is in backwardation, it usually signifies scarcity. Somebody will pay anything to get that commodity right now; they’ll pay a higher price right now, and they’ll pay less in the future. But in contango, usually there’s fear of a glut, or there’s not as much of a concern about scarcity. Thus, that front month contract is priced lower.
So, if you’re rolling those futures contracts each month, and you’re having to buy something that’s more expensive each month, that causes degradation of the performance. That is negative roll yield. That has frustrated commodity investors for years.
Our products use an “optimum yield” methodology, meaning our models look across all the different commodities that are in the DBIQ Optimum Yield Diversified Commodity Index Excess Return and, based on the shapes of each individual curve, determines where on the curve it makes the most sense for us to own those futures contracts. So, for example, sometimes, it’s buying a year out on sugar. Or, right now, we have some backwardation in some of the commodity markets, so the model will say we should stay toward the front [months in those commodities].
The beauty of PDBC, in particular, is that there’s an active management element too. We have portfolio managers also looking at the fundamentals of these underlying markets. So, for example, even if the optimum yield methodology says “buy more than a year out,” the managers might take a view to be closer to the front of the curve, to experience some of the potential upside, if they think there’s going to be more scarcity in a commodity than is reflected by this optimum yield technology.
Crigger: You mentioned that some commodities markets have recently shifted from contango conditions to backwardation. Which ones are looking more backwardated, and what factors are contributing to that scarcity?
Kriskey: I think the best example is oil. Right now, West Texas Intermediate and Brent (which is a global reference out of Europe) both of those markets are in backwardation. It makes perfect sense, because as we come out of this pandemic, we are seeing increased demand for energy-based commodities: We’re seeing more cars on the road, more people willing to fly.
But I think it’s not just this increasing demand as the world comes back, but also constrained supply. We recently saw that the inventory levels are lower than expected for WTI, low-sulfur diesel, and gasoline.
We also had big reductions [in supply]. The Organization of the Petroleum Exporting Countries (OPEC) implemented the biggest cut in history, and they have been very disciplined in putting barrels back on the market. That sort of surprised people, but they do have capacity and they could flood the market if they wanted to. But we think that they won’t; we think they’ll continue to be disciplined. The other area is U.S. shale. They have also been very disciplined in not flooding the market with oil. They are focusing more on income rather than increased production.
Crigger: What’s your expectation for inflation? We’ve seen some big prints lately. How much inflation do you think we’ll see—and will it be transitory, or long-lasting?
Kriskey: Back in August 2020, Chairman Powell from the Federal Reserve (Fed) changed policy from managing around an inflation cap of 2% to working around an average of 2%. That allows the Consumer Price Index (CPI) to go much higher, because we’ve been well below that target of 2%. Basically, the Fed is saying we’re going to allow for inflation. We’ve recently seen big increases in CPI.
A lot of investors are saying this inflation is going to be transitory, that the Fed wouldn’t let us have runaway inflation. But I do think that as we come out of this pandemic, there will be issues that people haven’t even considered. Just look at all the different supply chains involved in producing a single finished product, like a car. We don’t even know what products we might not be able to access. As a result, there could be serious pockets of inflation. Broad-based commodity indices are one potential hedge for this type of surprise or unexpected inflation.
Crigger: There are no shortage of inflation protection assets, however.
Kriskey: So, [for example, let’s]look at the beta, as in, the sensitivity to inflation, for the benchmark for PDBC. It’s high in energy; it’s more than 50% energy. And energy is a big component of inflation. So [PBDC’s] beta to inflation is about a 17:1. What that means is a roughly 5% commodity allocation would potentially cover 100% of your inflation risk. Whereas investments like Treasury Inflation-Protected Securities (TIPS) have a much lower relationship to inflation, and real estate investment trusts (REITs), while they’re historically reliable hedges for inflation, you’d have to buy a lot of them, because they’re less efficient at hedging inflation. Commodities are potentially a better hedge against inflation.
There’s also gold. Historically, gold has been a good hedge for inflation. But we looked back in history, and gold was better in the 70s, because inflation was much higher, at an absolute level, but also more volatile. Whereas now, inflation levels are very muted and low. So, while we do believe we’re going to see a pickup in inflation, we don’t believe it’ll be volatile or go to that very high level.
So that’s why we think that while gold is a good hedge, broad-based commodities still make a better, more efficient hedge for inflation. Gold is more of an “oh, my goodness” hedge. Like, the world is ending, I need to own gold. But I don’t know that a lot of people believe the world is ending. So they don’t generally need this sort of “oh, my goodness” hedge.
Crigger: We’ve seen a lot of short-term interest and massive influx in investor flows into commodities funds like yours. Have investors who haven’t invested in commodities yet missed the boat?
Kriskey: I get this question from investors all the time: have I missed my chance? I’d say two things. One: As an equity investor, haven’t you very often felt like, “wow, I missed that big equity move up, so I’m not going to invest at all in that equity,” and then you kick yourself two months later, when it continues to go higher?
Also, you can still buy the dip, right? And two: there is a strong fundamental story for commodities as well. One thing we didn’t talk about is copper. A lot of the story for copper is this infrastructure build out that we’re expecting, but we haven’t seen shovels in the ground yet. Yet the copper price has already hit historical highs. We believe we are in the early innings of the cycle, and we might see some pullbacks in some of these markets.
So if your goal is to hedge against inflation, and you also believe in the long-term fundamentals story and strength of commodities, then we think it makes sense to use those dips to layer in some commodity exposure.
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1 An investment cannot be made directly into an index. The S&P GSCI Total Return Index is a diversified commodities index that tracks the performance of the global commodities market. The Bloomberg Commodity Index tracks the performance of a diversified basket of global commodities.
2. The DBIQ Optimum Yield Diversified Commodity Index is a rules-based index composed of futures contracts of the 14 most heavily traded and important global commodities.
3. Roll yield is defined as the return earned after an investor rolls a short-term futures contract into a longer-term futures contract and profits from the convergence of the futures price toward a higher spot price.
4. Source: Invesco as of 6/30/21. Both PDBC and DBC individually had 15.32% and 13.58% exposure to West Texas Intermediate Crude Oil and Brent Crude Oil, respectively.
5. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Source: U.S. Bureau of Labor Statistics as of 6/23/21. An investment cannot be made directly into an index.
6. Source: Bloomberg LP, US Bureau of Labor Statistics, as of April 2021. The inflation beta of commodities was 17.24. 17:1 ratio mentioned refers to the inflation beta of 17.24, relative to a constant of 1 for inflation.
7. Source: Bloomberg LP, US Bureau of Labor Statistics, as of April 2021. The inflation beta of commodities was 17.24 versus REITS (5.25) and TIPS (3.23). Inflation beta is a metric used to evaluate an asset class’ ability to hedge inflation. It measures the change in inflation against the return of the asset class over a specific time period (1998-2020 in this example). The inflation beta for commodities is measured by the DBIQ OY Commodity Index, which is a rules-based index composed of futures contracts of the 14 most heavily traded and important global commodities. The inflation beta for REITS is measured by the FTSE NAREIT All Equity REITS TR Index, which contains all tax-qualified RETIS with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria (source: FTSE Russell as of 7/15/21). REITs are companies that own and/or operate income-producing real estate. The inflation beta for TIPS is measured by U.S. Treasury TIPS. TIPS are securities designed to adjust with inflation. According to TreasuryDirect.gov as of July 2021, “The principal of a TIPS increases with inflation and decrease with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A REIT is a special purpose vehicle that owns, operates or finances real estate assets. This type of investment helps investors get access to real estate without having to manage the properties themselves directly.
8. Source: RBC Capital Markets as of July 2021. ‘Gold Strategy: An Inflated Narrative’. In the 1970s, inflation surpassed 12% and gold, a commodity, increased in price as inflation increased during that decade.
Not a Deposit | Not FDIC Insured | Not Guaranteed by the Bank | May Lose Value | Not Insured by any Federal Government Agency
The opinions expressed are those of Kathy Kriskey as of June 7, 2021, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments. In general, equity values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. REITs are pooled investment vehicles that trade like stocks and invest substantially all of their assets in real estate and may qualify for special tax considerations. REITs are subject to risks inherent in the direct ownership of real estate. A company’s failure to qualify as a REIT under federal tax law may have adverse consequences to the REIT’s shareholders. REITs may have expenses, including advisory and administration, and REIT shareholders will incur a proportionate share of the underlying expenses. Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.
This Fund is not suitable for all investors due to the speculative nature of an investment based upon the Fund’s trading which takes place in very volatile markets. Because an investment in futures contracts is volatile, such frequency in the movement in market prices of the underlying future contracts could cause large losses. See the Prospectus for risk disclosures.
Commodities and futures generally are volatile and are not suitable for all investors.
The value of the Shares of the Fund relate directly to the value of the futures contracts and other assets held by the Fund and any fluctuation in the value of these assets could adversely affect an investment in the Fund’s Shares.
The Fund may experience significant losses as a result of global economic shocks. Specifically, oil experienced shocks to supply and demand, impacting the price and volatility of oil may have an adverse effect on the Fund.
Please review the prospectus for break-even figures for the Fund.
The Fund is speculative and involves a high degree of risk. An investor may lose all or substantially all of an investment in the Fund.
The Fund is not a mutual fund or any other type of Investment Company within the meaning of the Investment Company Act of 1940, as amended, and is not subject to regulation thereunder.
Shares in the Fund are not FDIC insured, may lose value and have no bank guarantee.
This material must be accompanied or preceded by a DBC prospectus. Please read the prospectus carefully before investing.
This Fund issues a Schedule K-1.
Invesco Capital Management LLC and Invesco Distributors, Inc. are not affiliated with Deutsche Bank Securities, Inc.
There are risks involved with investing in ETFs, including possible loss of money. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Risks of futures contracts include: an imperfect correlation between the value of the futures contract and the underlying commodity; possible lack of a liquid secondary market; inability to close a futures contract when desired; losses due to unanticipated market movements; obligation for the Fund to make daily cash payments to maintain its required margin; failure to close a position may result in the Fund receiving an illiquid commodity; and unfavorable execution prices.
In pursuing its investment strategy, particularly when “rolling” futures contracts, the Fund may engage in frequent trading of its portfolio securities, resulting in a high portfolio turnover rate.
Commodity-linked notes may involve substantial risks, including risk of loss of a significant portion of principal and risks resulting from lack of a secondary trading market, temporary price distortions, and counterparty risk.
The Fund may hold illiquid securities that it may be unable to sell at the preferred time or price and could lose its entire investment in such securities.
The Fund currently intends to effect creations and redemptions principally for cash, rather than principally in-kind because of the nature of the Fund’s investments. As such, investments in the Fund may be less tax efficient than investments in ETFs that create and redeem in-kind.
Investments linked to prices of commodities may be considered speculative. Significant exposure to commodities may subject the Fund to greater volatility than traditional investments. The value of such instruments may be volatile and fluctuate widely based on a variety of factors. Prices fluctuations may be quick and significant and may not correlate to price movements in other asset classes.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
Leverage created from borrowing or certain types of transactions or instruments may impair liquidity, cause positions to be liquidated at an unfavorable time, lose more than the amount invested, or increase volatility.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Fund and tender those Shares for redemption to the Fund in Creation Unit aggregations only, typically consisting of 10,000, 20,000, 25,000, 50,000, 75,000, 80,000, 100,000, 150,000 or 200,000 Shares.
Invesco Capital Management LLC, investment adviser and Invesco Distributors, Inc., ETF distributor are indirect, wholly owned subsidiaries of Invesco Ltd.
Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Fund call 800 983 0903 or visit invesco.com for the prospectus/summary prospectus.07/21 NA5874
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