USCI - 2023 Strategy For Hedging Value With Commodities Using IVE And USCI ETFs

Summary

• There are reasons to believe that the value strategy as exemplified by IVE should continue to outperform the broader market in 2023.
• However, with the unprecedentedly high-interest rates, and recession risks in the U.S., it is important to be prudent and protect your portfolio.
• This protection can take the form of hedging, namely by using the basket of commodities provided by the USCI ETF.
• I illustrate the hedging strategy using historical data and also extrapolate the results to show how it can be used to absorb losses in IVE during 2023.
• The rationale behind this thesis is to think differently.

In a market where the S&P 500 has lost more than 18% this year, the value strategy as embodied by the iShares S&P 500 Value ETF ( IVE ) has held up relatively well with nearly three times fewer losses as shown in the blue chart below. Tellingly, during the same period, the United States Commodity Index ( USCI ) delivered gains of 29.6%.

Now, with the Federal Reserve planning to continue tightening monetary policy next year, it makes sense to stick to the value ETF as I will elaborate upon later. However, it could be adversely impacted by the U.S. Central bank's intent to raise interest rates at a less aggressive pace in 2023 in order to tame inflation which could be more beneficial to growth names. There are also escalating recession risks in the United States.

In these circumstances, instead of selling your IVE shares, buying the dip, or adopting a wait-and-see approach, this thesis will show the attractiveness of a hedging strategy using USCI, but, first, a more detailed explanation of the above chart is warranted.

The Relation between IVE and USCI

The chart shows that IVE's and USCI's share prices have not moved in tandem or together for the last year. This means that market forces impact their price actions in different ways. Moreover, while the Commodity ETF has had the upper hand most of the time, there were occasions when IVE has been less volatile, namely in June.

Therefore, these two ETFs exhibit characteristics which make them suitable for a hedging scenario as I will later demonstrate using an example including historical data.

In the meanwhile, looking into alternative hedging strategies, investors will note here that due to the Fed rates that will likely continue to rise in 2023, I do not believe that bonds constitute valid hedging strategies unless Chairman Powell shifts to a much more dovish tone. A glance at the performance of this asset class in 2022 shows that those who laid their trust in it, mostly in anticipation of a Fed put (shifting to accommodative monetary policy) have been proved wrong, especially in the second half of the year.

On the other hand, gold as shown by the blue chart and which is included in USCI's commodity portfolio (figure below) seems to be on a sustained path to recovery.

Now, a rising dollar does not bode well for commodities in general, but, in the same way as in 2022, demand-supply and geopolitical factors point to continued strength for this asset class next year. For this matter, I recently elaborated on the commodity supercycle of 2023 in my thesis on the BlackRock Resources & Commodities Strategy Trust ( BCX ), amid the mild recession expected to hit the economy in H2-2023.

USCI and the Hedging Strategy

Therefore, having some commodity either on a standalone basis or using a hedging strategy makes sense. Now, the reason for singling out USCI is that it holds listed future contracts of crude oil, natural gas, agricultural products, and industrial and precious metals as pictured below.

The ETF tracks the SummerHaven Dynamic Commodity Index Total Return whose 14 selected contracts are equally divided into five sectors consisting of petroleum (brent crude, WTI crude, natural gas), precious metals (gold, silver, platinum), industrial metals (copper, aluminum, etc), grains (wheat, corn, soybeans, etc), and non-primary (sugar, cattle, etc). It may also hold swap contracts.

However, as an actively managed ETF, fund managers charge 1.01% and also note that USCI is less liquid compared to peers like BCX in terms of assets under management ('AUM') and average daily dollar volume. On the other hand, its price performance has been superior whether in the short or long term and it makes sense for hedging purposes where you are not trading big volumes on a frequent basis.

Going deeper into the hedging strategy, the price action seen in the introductory chart is translated into figures in the table below and expanded to include time periods of three years and beyond. In the last month for example, or a period marked by uncertainty and the Fed hiking rates by 50 basis points compared to 75 before, IVE has suffered from a 3.7% decline in contrast with USCI which has benefited from a 3% rise. This is due mostly to the strength in oil and industrial metal prices mostly associated with the China Covid reopening.

In this period using an example of $1000 invested in IVE and hedged by $500 through USCI, the investor would have obtained $1,478 or $22 less than the initial amount of $1,500 invested. On the other hand, for all other periods, a net gain is obtained, signifying that the hedging strategy works. Still, it must also be pointed out that the gains do not include the above 2 % dividend yields paid by IVE.

Now, these gains are based on historical prices and there is no guarantee that history will repeat itself, but, with the fight against inflation continuing to be prioritized in 2023, the underlying Fed monetary policy should not undergo drastic change. Also, with the Ukrainian conflict entering a new phase, commodity prices, mainly petroleum, and grains should get some support.

The Appeal of Value in 2023 and Beyond

This makes the case for investing in commodities alluring, but, a lot of the current upside has been tied to the China Covid reopening story and rapid relaxation of control measures is resulting in rising infection rates. Therefore, expect some pullback in January when the effects of Covid on economic activity start to be publicized.

On the other hand, the value strategy should continue to get traction, or at least prevail on growth as has been the case during the last month . It should also be supported by the fact that analysts at Goldman Sachs cut 2023 EPS growth for S&P 500's holdings to zero. This forecast is based on macroeconomic uncertainty which has in turn influenced CEOs to reduce spending. This should be particularly detrimental to growth stocks that rely on aggressively growing their revenues to increase profit margins in order to increment earnings.

In contrast, there should be more limited effects on IVE’s "value" holdings that rely more on stable revenue growth to increment their earnings. These holdings are spread (diversified) mostly across financials, IT, Industrials, Consumer Discretionary, and Healthcare as pictured below.

Thus, in a period likely to be marked by higher borrowing costs which also increase the probability of a Fed-engineered mild recession, the value strategy should hold up better in 2023. Another reason for this is that after having been behind the curve for inflation control at the beginning of 2022, it is unlikely that the Fed will loosen monetary conditions any time soon.

Hedging for Unprecedented Times

In support of a long-term case for the value strategy, IVE has delivered a 117% gain over the last ten years as shown in the above hedging table, but this is a long time and most of this period has been characterized by near-zero interest rates.

Now, with the effective Fed Fund rates at an unprecedented 4.33% after having risen by 2,310% over the last ten years as shown in the pale blue chart below, liquidity conditions are unlikely to be the same in 2023. Consequently, it is high time to protect your value portfolio, and this time the most appropriate strategy is to hedge it using a basket of commodities which includes gold.

Noteworthily, due to its hedging role, USCI is to be used over a limited period, say one year. As I mentioned earlier, the price of commodities or raw materials in general remains sensitive to interest rates. As such, prices should normally fall when rates rise but this has not been the case in 2022 and should not be the case next year for reasons mainly connected to China as I have elaborated above. This same China factor should support demand in case a mild recession hits the U.S. as the East Asian country dominates world trade as one of the largest commodity importers.

Conclusion

To sum up, using historical data, this thesis has shown that hedging IVE with USCI as part of a 2:1 ratio works in most of the periods spanning from one month to ten years.

Extrapolating further, assuming that the commodity ETF just returns 15% or half its 2022's gains next year, I have a target of $64.3 (55.9 x 1.15) based on its current share price of $55.9. The resulting growth based on an investment of $500 in USCI allows you to incur a loss of up to 6% (-6%) on $1,000 made on IVE without actually losing money as the $1,515 obtained is more than the initial amount of $1,500 invested as illustrated below.

Finally, these gains do not include the quarterly dividends paid by IVE. This said some may opt to invest in the commodity ETF, but, thinking differently, the bottom line is that it can also be used by value investors to navigate through uncertainty while remaining invested.

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