What's coming down on commodity ETFs?

The full transcript is available to read below.

Paul Justice: Hi. I'm Paul Justice, ETF strategist with Morningstar. Today I'm joined by executive vice-president of global product development for PowerShares, Ben Fulton. Thank you for joining me, Ben.

Ben Fulton: Thanks Paul. Pleasure being here.

Justice: Commodity ETFs have been in the news a lot recently. We've seen regulatory action by the CFTC and Senate and Congress review of some of these funds. They are immensely popular. What are some of the problems right now that are coming down on commodity funds, and how is PowerShares adapting to this dynamic environment?

Fulton: Well, commodity products, needless to say, have been very embraced and successful in the marketplace for ETFs. And ETFs have been able to help, really, open an asset class that in the past was probably a little harder for investors and even certain institutions to be able to get to.

But with success becomes a lot of AUM, a lot of assets, and some unique situations. So I think the CFTC took a step back just to say, "Let's look at this. Let's look at levels. How should we look at these products and how should we work together in conjunction with the product developers to both build the product for future success and to broaden out the solutions?"

So part of ours was we took some of the indexes, we worked with Deutsche Bank, broadened the indexes out to add some additional commodities to those in DBC/DBA, which is our broad commodity and our agricultural commodity.

DBA, for example, is primarily grains. It was your largest grains. And now we've some additional grains and some of the components, and we added the meats into that marketplace. So that was an example of working in conjunction, trying to understand the risk as the regulators saw it, and yet also try to keep a product that we think is very vital towards risk management and future asset management needs.

Justice: So these products have been a great diversifier for people to add to a stock/bond portfolio and you're making them better now by introducing more commodities into the mix, and also, dealing with the solution that regulators would look at as far as position limits and any futures contract.

Fulton: I think it is vital. I think it's one of those areas that, for a long time, financial planners and the endowment managers looked and said alternative assets are key and vital because of the low correlations, some attributes that they can bring to a portfolio that will help mitigate risk in bad markets and create, we will say, a better portfolio for investors.

But it was always tough to really be able to access that marketplace, have something that had breadth and you could hold for long periods of time. I think the ETF...We may still be in its infancy. I mean there has been a lot of success in this product range, but like most ETFs, it is driven by demand in the marketplace, and then you see expansion of indexes. So you are seeing a lot more people coming forth with new approaches, new ideas of how you couple, whether it is commodities and futures, together and currencies, and different aspects. So it will be interesting to see how the world looks five years from now in the ETF world.

Justice: Now, some people have argued in the last year that the correlations of commodities with equities and bonds have gone up. Do you think that will persist over time or is the long-term benefit really still there?

Fulton: I think the long-term benefit is there. There are certain commodities, as we all know, that have a very high correlation. Since so many of the older commodity indexes were oil-laden, they probably had a lot more correlation.

But there are a lot of contracts now that were not even available in the US marketplace, like the CME Group that is based here in Chicago. And CME now has fostered relationships with Singapore Exchange and others. They're bringing palm oil and rubber--you know, other contracts in the past. It could be a very large marketplace. There could be a lot of hedgers and providers in the marketplace, but it was never viewed as an investment tool.

So I think you'll see that follow through, but it'll probably be by an expansion of what you see in the futures marketplace. And then from that, you'll have index providers continue to pick up those contracts as they develop indexes.

So I think the raw materials, raw commodity marketplace, is booming along with the emerging market countries. I mean that has really been the biggest driver. Oil may have high correlations, but a lot of them we will call newer, or at least new to the U.S. marketplace, commodities, I think will still show low correlation and have some unique features to it.

Justice: Now, with added product differentiation, you do bring some complexities to, say, individual investors, and that brings up the suitability question. I would say that not all these products are suitable for everyone, but there's a product out there that's right for people.

Fulton: I think that's great point. I always think products by themselves are amoral. People will say that's a good product or a bad product. The reality is they're a product.

But suitability of who should use them is a decision. So that's where I think advisors definitely need to do their homework. Investors needs to study and really do the research ahead of time, especially when they start looking in the alternative space.

Not all commodity indexes or ETFs are created alike, so they're going to have different natures. And it's not one that you just want to go in and buy the largest because the largest must be the best product. You want to really understand what that means, how it's going to work, and what the attribute is.

So you want to look at the underlying contracts, possibly how they roll the futures contract. If a person doesn't understand the roll nature of those, then that is the first place they want to do. They want to understand that. They want to understand how the product operates with exposures they have and then where that takes them.

So it's not for all investors, but I think for the wealth managers, for institutions, and then endowments and different groups, I think it's a welcome event to have these products available out there.

Justice: I agree. And with that, I'm Paul Justice from Morningstar, and thank you for joining me, Ben.

Fulton: Thank you.