White Paper Commodities as a Asset Class

White Paper Commodities as a Asset Class As consumers, we feel the impacts of commodities – whether it is at the gas pump, grocery store or in our ene...
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White Paper Commodities as a Asset Class As consumers, we feel the impacts of commodities – whether it is at the gas pump, grocery store or in our energy bills. As investors, we need to know what they offer and how we gain exposure to them. A tangible asset that can be used as an input to produce another good or service, commodities are uniform in quality, meet minimum standards, encompass a wide range of categories, including livestock, oil, grain, sugar, gold and cotton and are traded in real time in physical quantities (spot) or in futures markets using contracts. Before the existence of exchange-traded funds (ETFs), investments in commodities were mostly limited to large, well-capitalized institutional traders because of transportation, storage and insurance costs related to holding the physical asset or the complications of holding futures contracts. Now, because of the convenience and accessibility of ETFs, commodities are widely available to all classes of investors. An ETF is a unique investment tool that combines some of the features of mutual funds with some of the features of individual stocks. Like a mutual fund, an ETF gives investors access to a group of securities through a single transaction. Like a stock, ETF shares are traded throughout the day on exchanges at market-determined prices. We see potential benefits to owning commodities as an asset class. For example, the added diversification by allocating a portion of assets to commodities may reduce overall portfolio volatility. Also, commodities may provide a potential inflation hedge, as the prices of goods and services typically increase along with the prices of the commodities used to produce them. As more investors have discovered the benefits of owning commodities, ETF providers have made investing in the world’s natural resources easier than ever. Types of commodity ETFs Commodity ETFs come in several forms, ranging from broad, all-inclusive commodity funds all the way down to narrowly focused single-commodity funds. There are three common types: futures, physical and equities. Futures. Most commodity ETFs receive exposure to commodities via futures contracts because futures are how most commodities are traded. A future is a promise to buy or sell a commodity for a set price at a set date in the future. A majority of the futures contracts traded on the exchange floor are settled or swapped for cash before the expiration date, meaning the owners of the contracts never take physical delivery, rather they roll to a contract expiring later in time. Futures contracts have three sources of return: spot return, collateral return and roll return. Spot return is generated by appreciation or depreciation of the commodity and collateral return is generated from holding US Treasury Bills or other securities used to secure a futures contract. Roll yield is the return, positive or negative, generated by rolling a shorter-term futures contract to a longer-term futures contract. Futures-based commodity ETFs come with a wrinkle adding a time component to the price creating potential tracking error or deviation in the form of roll yield. Rolling a contract is the process of exiting a position in the current contract and entering a position in a later-dated contract. This time component comes into play with contango or backwardation.

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As depicted in Figure 1, contango is when futures prices are trading at higher prices than spot prices and the futures curve slopes upward over the given time period. Contango imposes a cost to roll a contract to a future month because the slope of the futures curve requires investors to pay a higher price to own later-dated futures contracts.

FIGURE 1 Contango 110

Contract Price ($)

108 106 104 102 100 0

1

2

3

4

5

6 Month

7

8

9

10

11

12

For illustrative purposes only

Backwardation is when futures prices are trading at lower prices than spot prices. In this case as shown in Figure 2, the futures curve will have a downward-sloping shape. In the case of backwardation, the investor actually collects a positive yield when rolling to a laterdated futures contract, as they are able to buy the later-dated contract at a discount to the price received for selling the near-term expiring futures contract.

FIGURE 2 Backwardation 100

Contract Price ($)

98 96 94 92 90 0

1

2

3

4

5

6 Month

7

8

9

10

11

12

For illustrative purposes only

2

Contango and backwardation are important to commodity investors because they determine the cost of rolling expiring contracts to contracts with later expiration dates. When markets are in contango, investors incur a cost to roll which may have a negative impact on returns. Conversely, backwardation leads to a positive roll yield. ETFs have largely mechanized this process and conventional indexes implement a front-and-secondmonth only roll process which rolls to the next available contract which typically leads to a negative roll yield in a contango market. Some ETFs have attempted to solve this problem by incorporating strategies that hold positions in markets that are in backwardation, or markets that have the least amount of contango. Instead of automatically rolling into the next-month contract, they use an optimum yield process to analyze the next 13 months and select the contract that seeks to generate the best “implied roll yield.” Essentially, this strategy seeks to minimize the negative effects of contango and maximize the positive effects of backwardation to produce optimal returns in futures-based ETFs. Physical. Also available are precious metal commodity ETFs backed by the physical commodity itself. This type of ETF is limited to precious metals because physically backing an oil or wheat ETF would involve enormous amounts of storage, making it unfeasible and very costly. Each share of a physically-backed ETF represents a fractional ownership of the physical commodity such as gold bars owned by the ETF. The bars are stored in secure vaults around the world. Retail investors may consider physical ETFs over holding the physical commodity because of costs associated with commodity storage. Equities. Lastly, investors can get exposure to commodities via equity ETFs, which typically hold companies such as miners and producers whose business is related to commodities. Processors and producers use raw materials to create intermediate or end products which may or may not be differentiated. Producers may focus on a specific commodity or they may engage in secondary production where they extract another commodity as a byproduct or result of the primary production process. Natural gas can be a byproduct of crude drilling. The health of commodity producers is impacted by production costs and price fluctuations in the underlying commodity. Influences in commodity markets It is a common misconception that commodities movements are hard to predict and are driven largely by sudden events causing rapid shifts and swings. While weather, disasters and production disruptions do have a measurable short-term impact, commodities have been observed to exhibit consistent periods of strength and weakness over succeeding seven-year cycles since the early 1970s. Recent research suggests that periods of freely floating nominal exchange rates may be associated with unique patterns of commodity price behavior – namely longer and larger real price boom/bust cycles.1 Exploring this research further over the last 40 years of commodity price activity following the decision in the early 1970s to let the US dollar float freely against major world currencies, we believe the data points to a seven-year market cycle in commodities. Market cycles are trends or patterns that may exist in a given market environment, allowing some securities or asset classes to outperform others. Historically, each seven-year commodity market cycle begins with a multi-year

1 Jacks, D. (2014), “From Boom to Bust: A Typology of Real Commodity Prices in the Long Run.” Simon Fraser University and the National Bureau of Economic Research 3

Viewing 40 years of price behavior in seven-year cycles in Figure 3 suggests that investors that entered the market near one of several peaks could have suffered many years of losses and waited years more to break even on the investment during such periods. FIGURE 3 The seven-year commodity cycle: Timing of entry historically made a difference

Cumulative index returns (=1)

6 5 4 3 2 1 0 1973

1980

1987

1994

2001

2008

2015

Source: Bloomberg L.P, Dec. 31, 1973 through Dec. 31, 2015. Based on exchange-tradable commodities within the US Bureau of Labor Statistics (BLS) Producer Price Index (PPI), including Food & Agriculture, Oil & Gas, Lumber & Wood, and Metals. Weights were based on 1972 BLS PPI weights. Past performance cannot guarantee future results. Index returns do not represent any fund returns. Unmanaged index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index.

Figure 4 illustrates that the first two years of a seven-year cycle presented a significant opportunity for profits with the exception of the 1980 cycle which was distinguished by the interest-rate environment and the resulting US dollar strength (+21%) during the first two years of the cycle. During this time, the Fed Funds target was as high as 20%. FIGURE 4 A closer look: Commodity returns during the first two years of the seven-year cycle

Cumulative index total return (=1)

50% 40.5% 40% 30% 20.1%

20%

13.3%

22.8%

16.9%

10% 0% -1.3% -10% 1980–1982

1987–1989

1973–1975

1994–1996

2008–2010

2001–2003

Source: Bloomberg L.P, Dec. 31, 1973 through Dec. 31, 2015. Based on exchange-tradable commodities within the US Bureau of Labor Statistics (BLS) Producer Price Index (PPI), including Food & Agriculture, Oil & Gas, Lumber & Wood, and Metals. Weights were based on 1972 BLS PPI weights. Past performance cannot guarantee future results. Index returns do not represent any fund returns. Unmanaged index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index.

The Producer Price Index (PPI) is based on exchange-tradable commodities that the Bureau of Labor and Statistics (BLS) includes in their monthly PPI calculations. Weights are rebalanced annually on December 31 of each year, and are based on the actual 1972 PPI weights published by the BLS. 4

Adding the US dollar (USD) currency to the seven-year cycle, Figure 5 illustrates that while the sevenyear boom/bust commodity cycle historically set the direction of commodity prices (higher in the first half of the cycle) the USD consistently regulated the magnitude of the price changes. There have been past cycles where commodities moved higher even in the face of a fairly strong dollar, but the size of the gains in commodity prices were reduced in proportion to the strength of the move in the dollar. An extreme example is when the headwinds from the strengthening dollar in 1980–1982 fully arrested the expected cyclical rise in commodity prices.

FIGURE 5 US dollar and commodity returns during the first two years of the seven-year cycle • PPI • Trade-Weighted Dollar 50% 40.5%

Cumulative index total return (=1)

40% 30% 20.9%

20%

16.9%

13.3%

10%

22.8%

20.1%

3.6%

3.6%

1.6%

0% -1.3% -10%

-8.0%

-20% -23.2% -30% 1980–1982

1987–1989

1973–1975

1994–1996

2008–2010

2001–2003

Source: Bloomberg L.P, Dec. 31, 1973 through Dec. 31, 2015. Based on exchange-tradable commodities within the US Bureau of Labor Statistics (BLS) Producer Price Index (PPI), including Food & Agriculture, Oil & Gas, Lumber & Wood, and Metals. Weights were based on 1972 BLS PPI weights. Past performance cannot guarantee future results. Index returns do not represent any fund returns. Unmanaged index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index.

Commodity prices are also impacted by global economic development, weather patterns, natural disasters, technological advances and environmental pollution regulations. For example, most North American coal producers have recently declared bankruptcy as global demand for coal declines in response to increasing regulation of greenhouse gas emissions and air pollution.

The Trade-Weighted Dollar is a weighted average of the foreign exchange value of the US dollar against a subset of the broad index currencies that circulate widely outside the country of issue. Major currencies index includes the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden. 5

Considerations for portfolio implementation Broad commodity ETFs include sub-sectors with differing levels of exposure. Commodity indexes cover four major subsectors: agriculture, energy, industrial metals and precious metals. The variations in the weightings implemented by fund providers may result in divergent performance numbers, so investors need to research sub-sector weightings and act accordingly. Commodities can contribute to a portfolio by offering potential diversification² and a hedge against inflation. Commodities continue to show the highest correlation to inflation of any asset class and have historically served as a better inflation hedge than Treasury inflation protected securities (TIPS).³

FIGURE 6 10-year correlation4 to inflation5 0.9 0.8

Correlation

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1

Commodities

TIPS

Gold

Emerging Markets

Developed Markets

US Equities

US Bonds

Source: Bloomberg L.P., as of May 31, 2016 Broad Commodities are represented by the DBIQ Optimum Yield Diversified Commodity Index Excess Return™. Gold is represented by spot, Emerging Markets by the MSCI Emerging Markets Net Total Return Index, Developed Markets by the MSCI AEFE Net Total Return Index. US Equities by the S&P 500 Index and bonds by the Bloomberg Barclays U.S. Aggregate Bond Index. TIPS are represented by the BofA Merrill Lynch US Inflation-Linked Treasury Index. Returns are rolling 12-month returns against year-over-year CPI. Past performance does not guarantee future results. Unmanaged index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index. Please see page 8 for index definitions.

Commodities have been negatively correlated to fixed income and have a low but positive correlation to equities.

² Diversification does not guarantee a profit or eliminate the risk of loss. 3 TIPS are issued at a fixed rate of interest with the principal adjusted every six months based on changes in the CPI. At maturity, TIPS are redeemable either at their inflation adjusted principal or their face value, whichever is greater. 4­ Correlation indicates the degree to which two investments have historically moved in the same direction and magnitude. 5 Inflation is measured by changes in the CPI Index. The Consumer Price Index, which reflects the price of a basket of consumer goods and services, represents the amount of inflation or deflation that the US economy is experiencing. 6

FIGURE 7 Five-year correlation to and among broad commodities

Broad Comm. Broad commodities

Energy

Base Metals

Agriculture

Precious Metals

World Equities

Bonds

1

Energy

0.91

1

Base Metals

0.65

0.5

1

Agriculture

0.65

0.42

0.34

1

Precious metals

0.56

0.34

0.56

0.42

1

World equities

0.59

0.56

0.55

0.38

0.23

1

Bonds

-0.11

-0.2

-0.07

0.01

0.29

-0.1

1

Source: Bloomberg L.P., as of April 30, 2016 Broad Commodities are represented by the DBIQ Optimum Yield Diversified Commodity Index Excess Return™, Precious Metals by the DBIQ Optimum Yield Precious Metals Index Excess ReturnTM, Base Metals by the DBIQ Optimum Yield Industrial Metals Index Excess Return™, Agriculture by the DBIQ Diversified Agriculture Index Excess Return™ and Energy by the DBIQ Optimum Yield Energy Index Excess Return™, World Equities by the MSCI World Index and Bonds by the Bloomberg Barclays U.S. Aggregate Bond Index. Past performance does not guarantee future results. Unmanaged index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index. Please see page 8 for index definitions.

Historically, there have been higher correlations between certain commodities, as different subsectors respond differently to global activity, production costs, economic conditions and political factors. For example, crude oil and natural gas have exhibited modest correlations to agriculture as input costs to run farm equipment and produce fertilizer, respectively. This is one reason why we believe diversified commodity ETFs can benefit the investor by offering exposure to multiple commodities and subsectors within one investment vehicle. Conclusion The advent of investible commodity benchmark indexes and the introduction of ETFs that track them have provided access to a unique asset class. Commodity ETFs offer cost-effective and convenient access to domestic and global commodity markets. Whether futures-based or physically-backed, ETFs can provide effective commodity exposure, and depending on investor risk tolerance, may be able to reduce overall portfolio volatility.

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Index definitions DBIQ Optimum Yield Diversified Commodity Index Excess Return™ is a rules-based index composed of futures contracts on 14 physical commodities. DBIQ Optimum Yield Precious Metals Index Excess Return™ is a rules-based index composed of futures contracts on gold and silver. DBIQ Optimum Yield Industrial Metals Index Excess Return™ is a rules-based index composed of futures contracts on widely used base metals such as aluminum, zinc and Grade A copper. DBIQ Diversified Agriculture Index Excess Return™ is a rules-based index composed of futures contracts on agricultural commodities. DBIQ Optimum Yield Energy Index Excess Return™ is a rules-based index composed of futures contracts on energy commodities such as light sweet crude oil (WTI), heating oil, Brent crude oil, RBOB gasoline and natural gas. MSCI Emerging Markets Net Total Return Index is an unmanaged index considered representative of stocks of developing countries. MSCI AEFE Net Total Return Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The S&P 500® Index is an unmanaged index considered representative of the U.S. stock market. Barclays US Aggregate Index is an unmanaged index considered representative of the U.S. investment-grade, fixed-rate bond market. BofA Merrill Lynch US Inflation-Linked Treasury Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of greater than one year. About risk There are risks involved with investing in ETFs, including possible loss of money. Indexbased ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply.

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money. Foreign securities have additional risks, including exchange-rate changes, decreased market liquidity, political instability and taxation by foreign governments. Investment in securities in emerging market countries involves risks not associated with investments in securities in developed countries. The economies of the countries in the Asia Pacific region are largely intertwined; if an economic recession is experienced by any of these countries, it will likely adversely impact the economic performance of other countries in the region. Funds focusing on a particular industry are subject to greater risk, and are more greatly impacted by market volatility than more diversified investments. Equity risk is the risk that the value of equity securities, including common stocks, may fall due to both changes in general economic and political conditions that impact the market as a whole, as well as factors that directly relate to a specific company or its industry. Dorsey, Wright & Associates, LLC is compensated for providing consultation regarding the Dorsey Wright PowerShares ETF Models. Invesco PowerShares Capital Management LLC is not affiliated with any Dorsey Wright company. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (PowerShares) 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 Funds call 800 983 0903 or visit powershares.com for prospectus/summary prospectus.

The information provided here is for educational purposes only and is not to be construed as investment advice, research or a recommendation of a particular strategy or product. P-CAC-WP-1-E

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