Below is a commentary originally posted at www.etfdigest.com on 23rd June 2005.
Every investor knows it's important to diversify their portfolios. However, just diversifying into various market sectors that trend in the same direction doesn't accomplish very much. Doing so may just add to transaction expenses and give investors a false sense of accomplishment.
Most knowledgeable investment professionals know that adding uncorrelated assets to an investment portfolio is more likely to accomplish true diversification, reduce risk and generate superior overall performance. New rumored and proposed commodity-based ETFs (silver, crude oil, and currency markets as well) are, for the most, part well-suited to achieve true diversification.
Most seasoned commodity traders are just as likely to be short a commodity as long. After all, we're dealing with commodities. Commodities market prices, and to a lesser extent bonds and stocks, are driven higher or lower purely by perceived and real supply/demand factors. Unlike stocks, commodities have no "earnings" or other similar fundamental issues that drive prices. Speculators and commercial hedging activities dominate whether for grains, energy, metals and so forth making for heavy two-way (long/short) activity.
Gold ETFs have been available for nearly a year and their issuance has been, and continues to be, well-received. Now an ETF for silver and crude oil (along with a rumored currency-based issue) are being proposed. This is potentially great news. Great, because adding these markets to a conventional investment portfolio can achieve true portfolio diversification. However, there's a big catch. If retail investors, like any typical commodity investor, are unable to short these commodity ETFs, then investors are deprived of the commodity diversification benefit - they can only be long or out.
Over the past two years, we've been discussing the difficulty retail investors have faced when trying to short most ETFs beneath the top half dozen or so issues. It's been a serious ETF short-coming that needs resolution especially if these new issues are released. (Read more about shorting ETFs)
Various ETF sponsors like to create these new issues when they perceive demand to be the strongest from a bullish perspective. This is understandable because they want a successful underwriting to earn fee income. Institutions are able to create new shares in increments of generally 100,000, (an amount well-beyond the typical retail investor's capacity) and then if they want, short. This suits sponsors because with each new share issued, they get more fee income. Retail investors are left to attempt shorting ETF shares that already exist in float. Sponsors have no financial incentive to assist them in this regard and most brokerage firm stock loan departments are appallingly unprepared.
Don't get me wrong, I'm very excited to have these issues available. They are the "missing link" that could allow mainstream investors the opportunity to achieve true portfolio diversification. However, I'm concerned that these new issues will have only a one-sided benefit. If retail investors are able to take advantage of all facets of commodity-based ETF investments, then the dream of individuals being able to create their own hedge fund can be realized. This would be a historic breakthrough.
