Navigating Commodity Volatility (Lee)

Navigating Commodity Volatility
Targeting Commodity Exposure for Short- and Long-Term Investors

Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management

May 31, 2011

Recent Developments:

  • Over the course of the last several weeks, commodity volatility has shown a sharp uptick (Chart A). This notable increase in realized volatility was caused by a number of factors, including the drop in risk appetite of global investors, further clarity in the Middle East political tensions and, most importantly, a succession of hikes in margin requirements by the CME Group Inc. (CME) for a number of commodities.
  • Leading up to May, we believed a number of commodities, particularly silver and oil, were largely overbought. In our view, the moves by the CME were needed to shake out some of the more speculative positions and lower the risk of an eventual bubble formation. We believe some of the commodities now better reflect fundamentals and the next several weeks may present some buying opportunities for longer-term investors, who can stomach higher portfolio volatility levels over the near term.
  • Over the long-term, we remain bullish on commodities as we believe it to be in a secular bull-run. However, over the short-term we believe concerns of another strong and sudden run in commodity prices may lead to further margin hikes by the CME, which may cap returns, thus leading to further volatility over the next several weeks or months. The CME has however stated that it is willing to trim margin requirements when volatility eases, making commodities more attractive from a long-term perspective. We believe targeted commodity exposure is both an attractive strategy from both a trading perspective and a means of reducing overall portfolio volatility.

Potential Investment Opportunity:

  • The recent sell-off in silver brings its price back to reasonable levels as sentiment indicators suggest it is neither overbought nor oversold here. Should the price of silver cross above its 50-day moving average and its ADX show positive directional movement (Chart B), we would view this as an attractive entry point, as long as the order is placed with a stop-loss. Exchange-traded funds (ETFs) provide investors with efficient access to this commodity.
  • From a portfolio construction perspective, we view gold as our top pick since it is the least correlated to equity market returns and it has a differentiated reaction to macro-risk when compared to other asset classes. A reallocation from more volatile commodities into gold may be warranted for investors constructing their portfolio under a risk-budgeting approach. This rebalance may further be justified given short-term sentiment in gold prices is again turning positive (a trend indicator) show positive directional movement (Chart C).
  • The BMO Precious Metals Commodity Index ETF (ZCP) is approximately 84% allocated to gold futures with the remaining 16% to silver futures. This may be of interest to investors looking predominantly for gold exposure, while also gaining limited exposure to silver prices.

Chart A: Individual Commodities Showing Different Realized Volatility

Brent-WTI Crude Spread of This or More is Extremely Rare Occurrence

Source: Bloomberg, BMO Asset Management Inc.

Chart B: Silver Could Present Some Short-Term Buying Opportunities

Silver Could Present Some Short-Term Buying Opportunities

Source:, BMO Asset Management Inc.

Chart C: Sentiment Returning for Gold Prices

Sentiment Returning for Gold Prices

Source: Bloomberg, BMO Asset Management Inc.

*All prices as of market close May 26, 2011 unless otherwise indicated.

Source: BMO ETFs

Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, a portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

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