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Minyan Op-Ed: Manufactured Inflation, Unexpected Results


Surge of interest in ETFs comes with a price.

Editor's Note: The following is an opinion piece written by Minyan Jeffrey D. Korzenik.

"The California Public Employees' Retirement System, the largest U.S. pension fund, may increase its commodities investments 16-fold to $7.2 billion through 2010 as raw materials prices surge to records. Calpers, which has about $240 billion in assets, agreed at a Feb. 19 board meeting to hold between 0.5 percent and 3 percent of its assets in commodities, spokesman Clark McKinley said. The Sacramento, California-based fund last year put $450 million into commodities, its first such investment."
- Saijel Kishan, Calpers to Boost Commodity Investments Through 2010, February 28

When we started paying more for a cup of coffee at Starbucks (SBUX) in October, little did we know that this dose of inflation may have been Wall Street's latest gift to Main Street. We're all aware of the financial industry's penchant for repackaging subprime mortgages, municipal bonds, and anything else that can generate an investment banking fee. These creations can serve useful purposes, but they often have unintended consequences. As commodity prices continue to defy the gravitational pull of an economic slowdown, it's time to take a closer look at Wall Street's latest products: vehicles designed to invest in commodities.

Financial instruments tied to hard assets are nothing new. Energy and metals producers have issued a handful of bonds whose coupon payments were linked to oil or gold prices. The Central Fund of Canada has offered gold bullion in a closed end fund since 1961, and Salomon issued a traded oil trust in 1990.

However, in size and prevalence, nothing compares to the recent explosion of Exchange Traded Funds (ETFs) tied to commodities. ETFs are investment vehicles which trade like stocks but represent broader baskets of securities, originally equity indices.

ETF assets have been growing rapidly on a global basis since their introduction in 1993. A gold ETF was first introduced in November 2004, and commodity-linked ETFs have since participated in the industry's growth. That pioneer vehicle, the streetTRACKS Gold Shares (GLD), is now one of the ten largest ETFs. There are now dozens of commodity ETFs, offering exposure to individual commodities, sectors, and broad indices.

Structured notes, equity traded notes and even some open-end mutual funds further support this trend. What was once a portfolio oddity is now a commonplace purchase by individuals and money managers.

Several factors spurred the creation of these ETFs. Work by Goldman Sachs and academics repositioned commodities as an investment "asset class." The dismal bear market of 2000- 2002 whet investor appetite for alternatives.

The acceptance of ETFs as investment vehicles and a broad commodity rally converged to increase demand dramatically. The commodity bull market was fueled by economic growth in developing countries, the fall of the U.S. dollar, the Iraq war, and government-supported ethanol demand. The good news is that in creating a vehicle that makes commodities look like stocks, Wall Street has made it easy for investors to participate in the rally. The bad news is that commodities are not stocks, and the differences hold some very important, real world implications.

These ETFs offer a conduit from the financial markets to the commodity markets, but there is an enormous size discrepancy between the two. A small outflow from the financial markets represents an enormous inflow for commodities, with price-moving potential. Returning to our Starbucks breakfast, the total global production of coffee in 2007 was worth about $20 billion. Coffee is a 3% weight in the Dow Jones Commodity Index and a 0.67% weight in the S&P Goldman Sachs Index. Small weights to be sure, but it would not take much of a reallocation of the $100 trillion in the global debt and equity markets to increase prices. To use a more concrete example, the World Gold Council publishes demand statistics for that precious metal. The primary component of demand for gold is for jewelry fabrication, led by purchases from India, China and the U.S. In 2006, the demand for gold purchased by ETFs and similar instruments exceeded all the jewelry demand from China. In 2007, ETF demand was just slightly below U.S. jewelry demand.

ETFs have turned investors and money managers, schooled in bond and stock markets, into commodity market participants. However, wealth creation markets (stocks), income generation markets (bonds), and risk transference markets (commodity futures) are different animals requiring different approaches.

Traditional speculators in commodities are indifferent to being long or short (betting on either price increases, or price decreases). The new participants in commodity ETFs have a decidedly long bias; of the 205 million shares outstanding in the largest gold ETF, only 7 million shares are short, for example. In addition, unlike the sale of gold bullion, shorting a gold ETF does not directly release any gold into the market - the investor may be short, but the ETF still holds the bullion long.

Investors and fiduciaries who are treating commodities as an "asset class" and index their exposure are also participating only on the long side of the market. This long bias means that the price pressure is only to the upside. As if long-only strategies in commodities weren't inflationary enough, current investment styles may exacerbate the situation. Many quantitative investment strategies use momentum disciplines – simplistically, buying stocks that are outperforming and selling them when they stop going up.

With operating companies this may work - after all, rising stock prices help attract and retain management talent, lower the cost of capital, and provide leverage for acquisitions – legitimately resulting in even higher stock prices. Commodities are different. Every commodity rally sows the seeds of its own destruction, as high prices prompt new production that ultimately drives prices down. This is all setting the stage for a potential "bubble" – buying at ever higher prices that make less and less sense.

The ramifications go beyond impacting individual investor portfolios. Undue inflationary pressures on commodities complicate the Federal Reserve's job at a time when the economy is skirting with a recession. There is also an economic productivity issue in tying up physical commodities in storage or in "virtual warehousing" through the futures market. There is some concern that this activity is distorting traditional cash/future relationships. The National Grain and Feed Association recently stated, "the marketplace is ill-equipped to efficiently absorb more investment capital," noting that these disruptions are increasing the costs to the producers and users, the very participants these markets were meant to serve.

Finally, the consumer suffers through higher prices in end products.

The commodity exchanges have safeguards designed to prevent anyone from "cornering the market" using futures – but these were designed to protect against a single control entity, in the manner of the Hunt brothers. The current pressures are coming from multiple sources. As it is, the Commodity Futures Trading Commission has proposed a rule change that would make the problem worse, allowing a "risk-management exemption" which would lift the existing constraints on this activity. The physical markets (cash or forward delivery) are also largely unregulated. None of this is to suggest that commodity prices should not have risen in recent years.

But, there is a question as to whether, under the influence of these new vehicles, we have gotten to the point where we are buying commodities simply because they've gone up. Is that really any different from buying tech stocks in the 90's and real estate this decade?

So, when you drive away (gasoline) from the warm Starbucks (heating oil), having consumed your caffeine (coffee), juice (frozen concentrated OJ), and muffin (corn, wheat, sugar), know that you've frittered away an entire asset class.

Before you call your stockbroker to replenish your commodity position with an ETF, you might think twice.

Jeffrey Dean Korzenik is the chief investment officer in Vitale, Caturano & Company's wealth management practice. He leverages his over 20 years of Wall Street experience to provide clients with market insight, asset allocation, prudent manager selection, and investment research. A recognized thought leader, Jeff has helped developed new securities including various first-in-industry investment vehicles. In addition, Jeff has been active in philanthropic training for the financial advisor community to better serve clients with charitable goals.

Prior to joining the firm, Mr. Korzenik was president of Salem Five investment Services where he led the bank's wealth management subsidiary. His career includes serving as senior analyst in the Smith Barney equity research division and the currency and interest rate futures analyst for PaineWebber, Inc. During his 15 years at Smith Barney, he held various executive level positions in New York and Chicago before moving to Massachusetts in 2001. Jeff is an active member in his community and is a member of various advisory boards of several educational and cultural organizations.

Jeff is frequently published and speaks on various topics including engaging the family in philanthropy, asset allocation, trends in fiduciary oversight, and derivatives and alternative investments.
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