Author’s note: This article was released to CEF / ETF Income Laboratory members on February 17th, 2022.
The Invesco DB Commodity Index Tracking ETF (DBC) is the largest diversified commodity index ETF in the market. The fund offers investors diversified exposure to commodity prices, through futures contracts. DBC should see strong, market-beating returns when inflation is high, as has been the case YTD. On the other hand, the fund’s long-term expected returns are close to zero, as futures contracts generate no earnings or cash flows.
As such, and in my opinion, DBC is appropriate for aggressive, short-term traders bullish on commodity prices. Long-term investors looking for commodity investments should consider commodity equity funds, due to their higher long-term expected returns. These include the iShares MSCI Global Metals & Mining Producers ETF (PICK), for global mining companies, and the iShares Global Energy ETF (IXC), for global energy stocks.
DBC – Quick Overview
DBC is a diversified commodities index ETF. The fund tracks the DBIQ Optimum Yield Diversified Commodity Index Excess Return, a relatively simple commodities index, which includes the following commodities.
Commodity exposure is gained through futures contracts. These are agreements to buy or sell a particular commodity on a specific date for a specific price. Said contracts are structured in such a way that buyers, including DBC, profit from rising commodity prices, but suffer losses from decreasing prices.
DBC should perform particularly well when commodity prices are rapidly increasing, which is common in most inflationary environments. Inflation has skyrocketed YTD, during which DBC has outperformed, as expected.
Considering the above, DBC’s investment thesis is quite simple. DBC outperforms when commodity prices are increasing, making the fund an appropriate investment for commodity bulls.
On the other hand, DBC should underperform when commodity prices decrease, as was the case before 2020.
DBC’s strategy, holdings, and performance are those of a commodities fund. As there are many of these, I thought to take a look at some of the benefits and drawbacks of DBC relative to other commodity funds, especially commodity equity funds. Let’s have a look, starting with the benefits.
DBC – Benefits and Investment Thesis
Diversified Commodities Exposure
DBC provides investors with diversified commodities exposure, while other funds and investments might offer exposure to a specific commodity. Diversification reduces portfolio risk and volatility, significant benefits for the fund and its shareholders. Diversification also reduces the possibility of underperformance due to idiosyncrasies in any one specific commodity.
As an example, during 2021 commodity prices in general skyrocketed, but gold and silver prices stagnated. These two precious metals, especially gold, are popular inflation hedges, but were ineffective inflation hedges during said year, due to idiosyncratic factors.
DBC, being a diversified commodities fund, performed reasonably well regardless, as the fund’s other commodities picked up the slack. Oil performed particularly well, for instance.
DBC’s diversified commodities exposure makes the fund the perfect inflation hedge. Insofar as inflation is high the fund should perform reasonably well, regardless of conditions in any one specific commodity. As mentioned previously, this is not necessarily the case for other funds, and so is a significant differentiator and benefit for DBC.
Pure Commodities Play
DBC’s commodities exposure is direct, gained through futures contracts. This makes the fund a pure commodities play, with effectively no exposure to other factors like valuation, investor sentiment, dividends, duration, etc. DBC should perform well when commodity prices increase, while the same is not necessarily true for other commodity funds.
As an example, we are currently going through a rotation away from relatively overvalued US equities, and into relatively undervalued international equities. Due to this, some US commodity equity funds have underperformed YTD, as is the case for the Vanguard Materials ETF (VAW). Similar international commodity equity funds have outperformed, including the iShares MSCI Global Metals & Mining Producers ETF.
Commodity equity funds might post sizable losses even when commodity prices are high, due to the aforementioned issues (valuation, etc.). This is, however, not the case for DBC: the fund is a pure commodity play, and should perform well when commodity prices increase. Valuations, investor sentiment, and other factors are immaterial. This is another significant benefit for the fund and its shareholders, and particularly appropriate for US equity bears.
DBC – Drawbacks and Risks
Futures Costs and Risks
DBC’s commodity exposure is gained through futures contracts. These contracts can sometimes be excessively expensive, leading to lackluster returns and even losses. Significant, double-digit losses and underperformance are possible, although relatively rare.
As an example, the United States Oil ETF (USO), which is meant to track the price of WTI oil, significantly underperformed relative to its benchmark during 1H2020. The fund strategy proved ruinously expensive and ineffective during a period of heightened market volatility. Although this was somewhat understandable, it was little consolation to the fund’s investors.
DBC’s futures contracts are costly, a negative for the fund and its shareholders.
On a more positive note, the fund is structured in such a way as to minimize these costs. Specifically, the index:
employs a rule based approach when it rolls from one futures contract to another for each commodity in the index. Rather than select the new future based on a predefined schedule (eg monthly) the index rolls to that future (from the list of tradable futures which expire in the next thirteen months) which generates the maximum implied roll yield.
The above is simply a more in-depth, technical explanation for the fact that the fund minimizes the costs involved in actually implementing its futures contracts trading strategy. Profits are possible, but unlikely. This is a significant benefit for the fund and its shareholders, and minimizes the possibility of significant losses due to issues with futures contracts costs / rolling.
I was not able to find a period of time during which these costs caused significant losses to shareholders. Although I can not guarantee that no such period exists, it does seem like the fund’s strategy works to minimize these costs, risks, and issues.
Low Long-Term Expected Returns
DBC’s long-term expected returns are quite low, as the fund’s holdings do not generate revenues, earnings, or cash flows. These are purely speculative derivative financial instruments, with expected returns of approximately zero. Other commodity funds, especially those focusing on equities, have underlying cash flows, higher long-term expected returns, and are broadly superior choices for long-term investors.
The above is quite easy to explain with an example. Let’s say oil.
If you invest in a barrel of oil, you own a barrel of oil. It might appreciate in value, but does not generate earnings or dividends, nor does it grow.
If you invest in Exxon (XOM), you own stocks in Exxon. These might appreciate in value, same as the barrel of oil. These also entitle you to your share of Exxon’s assets, earnings, and dividends, which tend to grow year after year.
Exxon’s long-term expected returns are higher than those of a barrel of oil, due to Exxon’s earnings, dividends, and growth.
As should be clear from the above, in the vast majority of cases it is better to invest in oil companies than it is to invest in oil as a commodity, especially in the very long term. This has been the case for the past decade or so, and by quite a large margin.
What is true for Exxon and oil funds is true for DBC and comparable investments too. DBC itself has significantly underperformed relative to, well, most commodity equity / equity funds since inception, and by quite a large margin.
DBC’s long-term expected returns are quite low, and much lower than those of most commodity equity funds. This is a significant negative for the fund and its shareholders, and make DBC a broadly inappropriate choice for long-term investors. In my opinion, only short-term traders should consider a short-term position in DBC, with few exceptions.
Conclusion – Strong Inflation Hedge
DBC’s diversified commodity exposure makes the fund an effective, strong inflation hedge. DBC should outperform when inflation is high and rising, as has been the case YTD. The fund is appropriate for aggressive, short-term commodity bull traders, but broadly inappropriate for long-term investors.