Under The Hood Of GRES: A Whole New Commodity ETF

by on November 10, 2009 | ETFs Mentioned:

Innovation is certainly nothing new in the ETF industry, as the last several years have seen the introduction of numerous asset classes, investment strategies, and geographies to the exchange-traded structure. The rise of the ETF industry has made exposure to commodities available to almost every investor, and innovation in the space has presented them with a number of options.

Many of the first generation of exchange-traded commodity products, which physically buy and hold underlying commodities such as gold and silver, remain among the most popular ETFs available. But as the industry has expanded and investors have embraced commodities as a valuable fourth asset class, options have expanded significantly.

Futures-Based Exposure

WheatThe high worth-to-weight ratio of gold and silver makes them well-suited for this type of structure. But the physical properties of many commodities make investment through physically holding these resources either impractical (e.g., livestock and food) or prohibitively expensive (e.g., most oil and gas). In order to offer exposure to energy and agriculture products, several issuers developed ETFs that track commodity prices through investments in futures contracts. While futures contracts generally maintain strong correlations with the spot price of the underlying commodities, the relationship is far from perfect.

Because futures markets are often in a state of contango, a futures-based strategy may generate inferior returns in certain environments, lagging well behind the theoretical return on the spot price of the underlying commodity. For example, between the beginning of 2009 and the end of October, spot prices on West Texas Intermediate (WTI) crude oil increased by about 67%, while the United States Oil Fund (USO) gained only about 10% over that period.

Still, futures-based ETFs present the most efficient way for most investors to gain exposure to many commodity prices. The United States Natural Gas Fund (UNG) has become two of the most popular exchange-traded products in the world, with a market capitalization of more than $3.5 billion and average daily volume of 30 million shares.

New Approach To Commodity Exposure

Last month, IndexIQ introduced the latest innovation in commodity ETFs, the IQ ARB Global Resources ETF (GRES). GRES tracks the IQ ARB Global Resources Index, a benchmark that uses momentum and valuation factors to identify global companies that operate in commodity-specific market segments. The index offers diversified exposure, holding companies in each of five traditional commodity sectors: livestock, precious metals, grains and food, energy, and industrial metals. In addition, the benchmark includes three less traditional sectors, including timber, water, and coal, thereby offering complete exposure to the universe of commodity-related equities. ETFdb Pro members can access ETFdb Category Reports for each of these sectors of the commodity market (if you’re not a member of ETFdb Pro yet, sign up for a free trial or read more here).

Similar to ETFs focusing on commodity-intensive equities, GRES invests in several well known global energy firms, mining companies, and food producers. The largest equity components of the IQ ARB Global Resources Index (as of November 9) were:

Company Weighting
BHP Billiton 4.6%
Veolia Environment 4.2%
Rio Tinto 3.1%
Hormel Foods 2.9%
Suez Environment SA 2.8%

But unlike most ETFs that invest in equities of commodity producers, GRES takes a short position in broad-based equity markets, using futures contracts to partially hedge away exposure to the S&P 500 and MSCI EAFE Index. By doing so, GRES reduces the exposure to broad U.S. and international stock markets, essentially isolating the commodity component of its underlying holdings (see our guide to inverse ETFs for a look at how similar strategies can be implemented).

Through the end of the third quarter, the index underlying GRES had delivered stellar returns relative to the DJ-AIG Commodity Index:

Index 1 Month 3 Month 12 Months
IQ ARB Global Resources Index 4.6% 10.7% 2.6%
DJ-AIG Commodity Index 1.6% 4.3% -23.7%
Source: IndexIQ

For investors looking to gain exposure to commodity prices, there are a number of options, each of which may be appropriate for different situations and different objectives. GRES may be an appealing option for those hesitant to gain exposure through futures contracts (perhaps aware of the potential for return erosion presented by contango), but looking to avoid (or at least minimize) simultaneous exposure to equity markets.

For more looks at all of the new ETF strategies introduced to investors, be sure to sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.