Stocks or futures—which offers the best way to play commodities? The answer, of course, is that "it depends." But in times of contango, says Satch Chada, equities may offer the greater edge.

Chada is a managing director and global head of Investor Solutions for Jefferies Asset Management, LLC, a wholly owned subsidiary of Jefferies Group, Inc. (NYSE: JEF). Jefferies Group now manages more than $3.2 billion in assets worldwide. Last year, JAM teamed up with Alps Advisors Inc. to launch the first family of commodity equities ETFs (NYSE Arca: CRBQ, CRBI and CRBA) based on the CRB Equity Indexes (CRB-EQ Indices). More recently, JAM again teamed up with ALPS to launch the new Jefferies | TR/J CRB Wildcatters Exploration & Production Equity ETF (NYSE Arca: WCAT). Prior to joining Jefferies, Chada was a managing director at Merrill Lynch, and led development of such products and platforms as the HOLDRS, ELEMENTS and TRAKRS programs

Recently, HAI Associate Editor Lara Crigger spoke with Chada about using equities to play the commodities markets, including the pros and cons of commodities stocks, why so many companies in WCAT are in natural gas and whether the record demand for commodities worldwide can continue.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): What advantage is there in using equities to access the commodities markets, over other means?

Satch Chada, managing director/global head, Investor Solutions, Jefferies Asset Management (Chada): First, they're simple. For example, equity-based ETFs distribute 1099s, which are simpler from a tax perspective than the K-1s distributed by futures-based ETFs. But also, if you take a look at the market capitalization of the equities in the CRB-EQ Composite Index, it's roughly between $4.5 trillion and $5 trillion; it's a gigantic market. If you take a look at the aggregate open interest in corresponding commodity futures, such as oil futures, it's an order of magnitude less. So equities are easy to access for investors; by comparison to their futures counterparts, they're highly liquid and highly tradable.

Crigger: But when you own commodity equities, are you really getting the noncorrelated returns the asset class is known for? Don't commodity equities behave more like equities than commodities?

Chada: Unless you're willing to own spot directly, there's no "pure" way to own commodities.

Crigger: What do you mean by "pure" way to own commodities?

Chada: Let's say that someone wants to own oil. But how do I own oil? Well, I can go buy a barrel of it, put it in my living room, and at some point decide to sell it. But that's not practical. So I go buy a futures contract. If my investment horizon is only a month, or whenever that futures contract matures, that's a fantastic way to own oil, because I know that futures contract and that barrel of oil are going to converge to the same price. But typically, investment horizons are much longer, so investors have to "roll" (sell the front-month contract and buy a back-month contract) those futures contracts forward every time they mature.

But in rolling, you've turned what was a very efficient way to access oil into a very indirect way to access oil. You have to liquidate your current futures contract, go and buy another futures contract that matures further out in time, and so on. And as investors roll their contracts forward, they have incurred significant tracking error and, at least over the past five years, have had to forgo significant performance as compared to the spot price of oil. So there's this assumption that commodity futures are a direct way to get exposure, but in reality, they aren't—not for the long-term investor in commodities. The direct way is to go buy a gallon of oil or buy spot commodities. For most commodities, investors can't own spot so easily, with the exception of precious metals.

And if you've owned ETFs or other investment products that track commodity futures indices over the last five years, our research indicates that you would have suffered from a 10-plus percent performance drag, relative to the spot price of commodity indices over that five-year period, due to the impact of contango.

Yes, investing in commodities via equities is not perfect, as the day-to-day correlation between commodity equities and spot commodity prices is typically lower than that of spot commodities and commodity futures. But given the competing means of doing it, we believe this is a valid way of accessing the space, particularly over long time periods. This is especially valid since investors are not going to have to deal with the cost of contango, and investors may earn a dividend yield if companies distribute dividends.

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