Liquid Alternatives: Traditional Commodities

This research note is produced by Elkstone in conjunction with our hedge fund and cta manager database partner, Nilsson Hedge.

  • Due to commodity markets’ cyclical nature, we do not believe there to be an expected positive market return and therefore we do not use ETFs to get exposure to them. We use active management instead.
  • Gold and silver are outlier commodity markets where we do believe there is explainable, positive expected return and thus use ETFs to get exposure to those markets.
  • We require both a diversification benefit along with a positive expected return to have a chance of consideration for our portfolios.

Whether to hold commodities within a portfolio is always an investment committee discussion. Commodities are usually added due to their diversifying nature. This diversifying feature is undeniable and therefore commodities is a great asset class for diversification; sugar demand lowering due to a trend towards healthy eating or Brent Oil increasing in price because of a pipeline explosion in the Middle East has fundamentally nothing to do with Apple’s earnings or the ability of the US Government to repay its debt. When we discuss what we want to achieve through portfolio diversification, what always gets said is a reduction in our drawdowns, but what is important is to highlight that we want to reduce our drawdown without reducing our return expectation by the same level. I could take a $100 equity portfolio and reduce my drawdowns in half by holding a $50 equity – $50 cash position, however my expected returns are also reduced by 50%, so it does not make sense to diversify by holding a cash position. We want to diversify our portfolio through strategies and markets that have an explainable positive return expectancy…if it’s not expected to make us money, we might as well just hold a cash position.

At Elkstone, our investment philosophy has us

  1. Requiring a positive return expectancy,
  2. Looking to achieve exposure to the desired markets and risks in the cheapest way possible,
  3. Looking for diversification when diversification is needed,
  4. Looking past the name of the market, strategy, investment process and investment vehicle type to analyse what risks and exposures are actually driving the return stream.

Oftentimes, a return stream can sound different and therefore diversifying, but is driven by the same underlying drivers and is therefore not additive to a portfolio. With this investment philosophy as governance, this short research note looks at whether we want to build our internal commodity investment exposure through passive or active management and through ETFs or alternative investment vehicles or structures.


As we always look at what we are getting from both a market/strategy and investment vehicle, we understand that with an ETF vehicle, we will get the following:

Trade Setup: Long/buy-only exposure

Cost: Cheap exposure relative to other investment vehicles

Liquidity: Daily liquidity and high volume

Management: Passive

Mechanism:   Passively invests in the futures contract of the underlying commodity[1]

Carry/Roll Loss:  A unique feature of commodity ETFs is that commodity markets are invested in monthly futures contracts which the ETF price is based off of and that’s how they get their commodity market exposure. These monthly contracts expire on a certain date each month. For the ETF to continue to have its required exposure in a commodity, they must close out the current [‘front’] month contract that is about to expire and open a new position in the next months contract which will become the new ‘front’ month after the expiration date. The price between the current front month which has to be closed and the price of the new, soon-to-be front month which I must buy to continue my position in the commodity are not the exact same price. The process of selling the contract which is about to expire and buying the contract that is about to become the new front-month contract is called the ‘roll’. The difference between the price of the current front-month that’s about to expire and the price of the next contract which will soon become the new front-month which I have to buy in to is called the ‘carry’. Being invested in commodities via ETFs and therefore Future contracts means that investors lose the ‘carry’ which would not happen if we were to physically hold the commodity. This carry lose over a long period of time can significantly lower the returns of commodity positions versus expectation. If Oil in January 2021 is $30 and in January 2022 is $45, it may seem like a 50% profit, however we would have to have ‘rolled’ our contract 12 times during that period and lost out on the difference in pricing of those 12 contracts [‘carry’] which would mean we weren’t able to profit off the whole $15 increase but rather $15 minus the sum of the difference price of contracts during each roll during the year.

[1] Different ETFs will have different future’s holdings. It may be all in the front-month contract or it may split its holdings in multiple contracts going out the curve. Each ETF’s holding procedure must be understood before investment into it.


Any commodity market’s price can be defined as the equilibrium of its supply and demand functions. These are physical markets where crops are grown, or metal is brought out of a mine in one location and are then transported to another part of the world to be used as a raw material or end-product. This process takes time where inefficiencies can occur and imbalances can take time to be resolved. As prices go up, there is a big effort to increase supply to take advantage of those increased prices which leads to too much supply for that price level which depresses the price back down. This supply-demand relationship continues over time causing prices to go up and down over a large range.

Market Support: Market drivers are different depending on which commodity market you are researching. The supply side of the equation can be heavily dependent on the weather while the demand side can come down to eating trends, electric vehicle demand or government infrastructure commitments.

Given the cyclical nature of commodity markets, we believe that there is not necessarily a positive return expectancy within the commodity markets, i.e. They are not long-term increasing and expected to continue in that manner. Essentially, whether you make money or not is based on the luck of timing of entry. Chart 1, Chart 2 and Chart 3 below looks at WTI Oil, Soybeans and the Deutsche Bank Commodity Index since 1991, 1991 and 2006 respectively. Given that we believe there to not be a positive expectancy, we should not expect to see money invested over the medium term, regardless of when we invested be profitable. Within each chart, an ‘X’ was added right before the past three significant equity market drops to also be able to eyeball their diversification benefit during those periods. The charts show that whether we made money in a commodity market is dependent on the luck of timing of market entry.

Chart 1:WTI Oil Price Since 1991

Source: Elkstone Private, Bloomberg

Chart 2: Soybeans Prince Since 1991

Source: Elkstone Private, Bloomberg

Chart 3: Deutsche Bank Commodity Index since 2006

Source: Elkstone Private, Bloomberg


As always, with every rule there are exceptions. There is one primary and one secondary commodity market exception that we’d like to touch on. Gold, and Silver to a lesser extent, behave in a different manner than most commodities. Gold has very little economic or industrial use and so its demand driver is not one of economic use as a raw input which has it fall into that cyclical supply-demand nature like other commodities described above. Gold is seen as a safe-haven asset and its demand is one of want for market turbulence periods. This safe-haven characteristic makes it a mainstay in many investors portfolios where they look for more during times of market stress which increases its price. Silver is similar except that Silver has far more industrial use and therefore can act more like a traditional commodity during an average day, however when volatility comes, investors move to silver just like they do gold during those periods for similar safe-haven characteristics. Due to this safe-haven characteristic of these precious metals, we do believe there to be an explainable positive return expectancy. Chart 4 and Chart 5 below shows the price of Gold and Silver respectively since 1991 where an ‘x’ is marked just before the previous three significant equity drops.

Chart 4: Gold Price Since 1991

Source: Elkstone Private, Bloomberg

Chart 5: Gold Price Since 1991

Source: Elkstone Private, Bloomberg


We are guided by our investment philosophy, and it is based on that philosophy that market, strategy and investment vehicle decisions are made.

Explainable Positive Expectancy

  • Does traditional commodity market’s systematic risk have positive return expectancy? In our opinion, no.
  • Does precious metal’s [Gold and Silver] markets’ systematic risk have positive return expectancy? In our opinion, yes.

Access desired market or risk exposure in the cheapest possible way

As we don’t believe there to be an expected positive return in the traditional commodity markets due to their cyclical nature, we prefer not to get exposure to their systematic risk via an ETF vehicle. For our liquid traditional commodity exposure, we prefer to get our exposure via actively managed strategies. A manager’s ability to both buy and sell within cyclical markets is key to providing an explainable positive expectancy which we want access to. As this access is not attainable via cheap, passive, long-only exposure [ETFs], we move up the fee spectrum to the cheapest access to the type of market risk exposure we do want which is an actively managed strategy combining systematic risk and idiosyncratic risk.

As with all rules, there are exceptions. Commodity markets that we do believe there to be structural explainable positive return expectancy is the gold and, to a lesser extent, silver markets. This is due the largest demand driver being demand for its safe-haven properties.

We are a fan of using private equity vehicles within commodity markets and will go into further detail as to why in a separate, future research note.


Liquid Equity Market Investing: Passive or Active?


Karl Rogers is the Chief Investment Officer of Elkstone Private. Elkstone is a family office managing the wealth of its principals, with a focus on real estate, venture and alternatives, and a Multi-Family Office, regulated by the Central Bank of Ireland, which provides both access to co-investing in our principals’ investment portfolios and traditional family office services to many of Ireland’s entrepreneurs and HNWIs. Previously to Elkstone, Karl was a Managing Partner with Athlon Family Office, Head of US Power Trading with RISQ, Managing Director of ACE Capital Investments, a hedge fund manager and a proprietary commodity trader.

Karl currently sits in the adjunct faculty for Trinity College Dublin’s M.Sc. in Finance program where he is both a guest lecturer in their alternative investment module and supervises the student’s theses and he is a Special Advisor to the ESG Foundation.

Karl has been referenced in major industry publications including the Wall Street Journal, Bloomberg and the Financial Times and has spoken at numerous family office and alternative investment conferences across multiple continents.

Connect with Karl on LinkedIn.