DBC: Simple Commodity Index ETF, Subpar Long-Term Investment

I’ve covered several inflation-hedge ETFs these past few months, including those focused on commodity futures, miners, equity inflation beneficiaries, and more. These have generally performed reasonably well, due to skyrocketing inflation, but should underperform as inflation is brought back under control. On the flipside, most of these ETFs have positive long-term expected returns, so can be held long-term without any significant issue. Correctly timing inflation would be best, if difficult, but holding long-term is fine too. At least that is the case for most of these funds. Commodity future ETFs, including the Invesco DB Commodity Index Tracking ETF (NYSEARCA:DBC), are an exception.

DBC’s long-term expected returns are close to zero, plausibly even negative, as the fund’s holdings do not generate any earnings, cash-flows, or income. Investors will receive approximately nothing from these funds if inflation normalizes, which seems exceedingly likely: inflation is slowing down, and the Fed is committed to fighting inflation ‘until the job is done‘. Inflation could always surprise to the upside, but I have no reason to believe that this will be the case, nor do I see any possible catalyst. Under these conditions, I would not be investing in commodity futures ETFs in general, or in DBC in particular.

DBC – Quick Overview

DBC is a diversified commodities index ETF, tracking the DBIQ Optimum Yield Diversified Commodity Index Excess Return. Commodity weights are reasonably well-diversified, fixed, and rebalanced yearly. Target weights are as follows.

DBC’s actual current weights do not significantly differ from the above.

DBC’s commodity exposure is gained through futures contracts. These are agreements to buy or sell a particular commodity on a specific date for a specific price. Said contracts are structured in such a way that buyers, including DBC, profit from rising commodity prices, but suffer losses from decreasing prices. Contracts are somewhat costly, but DBC take steps to minimize said costs.

DBC should perform well when commodity prices increase which, almost by definition, occurs when inflation is high and rising. Inflation has risen these past twelve months, during which DBC has performed quite well, as expected.

DBC is a simple diversified commodities ETF, performs quite well when commodity prices increase / inflation is high and rising, and is a fantastic trading vehicle for commodity bulls. There are, however, many funds with broadly similar characteristics, including those focused on energy equities, miners, and more. DBC does have two important advantages relative to most of its peers. Let’s have a look at these.

DBC – Advantages

Pure Commodities Play

DBC’s commodity price exposure is direct, gained through futures contracts. Said contracts are explicitly structured to deliver profits when commodity prices increase, ignoring issues of valuation, investor sentiment, dividends, etc. If oil prices increase, oil futures prices increase too, boosting DBC’s share price, with very few exceptions.

Most other funds focus on securities with indirect commodity price exposure. Energy equities, for instance, should see higher share prices when oil prices increase, boosting energy fund share prices in turn. Importantly, energy equities are not structured to ensure that this is the case: their actual performance is dependent on many factors, including fundamentals and investor sentiment. Energy equities could easily underperform even as oil prices increase, for a myriad of reasons.

As an example, energy indexes were barely up during 2H2020, even as oil prices skyrocketed. Energy’s subpar performance was almost certainly due to bearish investor sentiment: the coronavirus pandemic was still in full swing and energy had performed disastrously for over a decade at the time. Investor demand for energy stocks was incredibly weak, strong prices and fundamentals notwithstanding.

Importantly, DBC itself does not suffer from these issues. As mentioned previously, the fund’s underlying holdings are structured to deliver profits when commodity prices increase, regardless of investor sentiment. DBC posted strong gains during 2H2020, as expected.

DBC’s direct commodity price exposure ameliorates the issues above, a positive for the fund and its shareholders. Said positive is particularly important for commodity price bulls, for obvious reasons. Said positive is also particularly important in the short-term, during which investor sentiment reigns supreme, less important long-term, during which fundamentals matter the most. As an example, DBC outperformed energy indexes during 2H2020, but the gap significantly narrowed in the next six months, as investor sentiment improved. Investor sentiment could have remained bearish for longer, but fundamentals do matter, and tend to take precedence over sentiment as time goes on.

Short-term, DBC significantly outperformed. Long-term, not so much.

Diversified Commodities Exposure

DBC provides investors with diversified commodities exposure, with exposure to most relevant commodities. Diversification reduces risk, volatility, and potential losses or underperformance due to idiosyncrasies in any one specific commodity.

Single-commodity ETFs, on the other hand, focus on one specific commodity, and so might underperform during a broad-based inflationary environment if their specific commodity does badly. As an example, silver and gold prices stagnated in 2022, even as inflation and commodity prices in general skyrocketed. Silver and gold ETFs, equity and commodity, both posted losses during the year, even though inflation has been quite high.

DBC, on the other hand, is a diversified commodities ETF, and so does not really suffer from said issues. As long as commodity prices are, in general, increasing, fund returns should be positive. Having a few laggards is not an issue, as other commodities can pick up the slack. As an example, DBC has posted very healthy gains in 2022. Gold and silver detracted from the fund’s performance, but oil and energy products more than made up for these losses.

DBC – Drawbacks

Low Long-Term Expected Returns

DBC’s most significant drawback is the fund’s low long-term expected returns. Prospective returns are low as the fund’s underlying holdings do not generate / entitle investors to any earnings, cash-flows, or income, unlike most other asset classes and peers.

Equities pay dividends. Exxon (XOM) currently pays 3.2%, and dividends tend to grow.

Bonds pay interest. I Bonds pay 6.9%, and interest should rise if inflation increases.

Oil futures pay nothing. Invest in oil futures, get 0.0% in dividends or interest, pay 0.86% to DBC for the privilege.

Oil futures would increase in price if oil prices increase, but the same is almost certainly true for Exxon and I Bonds too. Exxon saw skyrocketing returns in 2022, as expected.

I Bonds have seen outstanding returns too, with yields skyrocketing to 6.0% – 9.0% these past few months (currently 6.9%).

DBC’s lack of earnings, cash-flows, or income, is the fund’s most significant drawback, and one which is particularly impactful long-term. Exxon’s dividends amount to less than 1.0% in a quarter, a rounding error. Short-term traders might prefer DBC’s more direct commodity price exposure over Exxon’s paltry quarterly dividends. Exxon’s dividends amount to a more respectable 3.3% in a year. In a decade, the company’s dividends would amount to more than 33%, and this is before considering dividend growth, dividend re-investment, and share buyback plans. These are incredibly important, and beneficial, for Exxon’s long-term investors, and almost certainly outweigh DBC’s more direct commodity price exposure.

At the same time, DBC pays nothing in dividends, interest and the like, unlike Exxon, other equities, bonds, and most other asset classes. This makes it extremely difficult for DBC to outperform relative to its peers long-term, as has been the case since inception.

As can be seen above, DBC has posted total cumulative returns of 13.2% since inception, more than two decades ago. Most major asset classes have seen much stronger returns during the same, including equities, treasuries, and energy equities. Exxon is up too. DBC was unable to compete with these asset classes, due to the fund’s lack of underlying earnings, cash-flows, and income.

In my opinion, and considering the above, DBC will almost certainly be unable to compete long-term with these same asset classes moving forward. In my opinion, this is an incredibly significant negative, and more than outweigh the fund’s other benefits.

Conclusion

DBC’s expected long-term returns are extremely low, a significant negative for the fund and its shareholders. As such, I would not be investing in the fund at the present time.