The tremendous surge in interest in exchange-traded commodity products in recent years has been well-documented. Billions of dollars have flowed into funds that offer investors an opportunity to either speculate on short-term changes in natural resource prices or tap into an asset class that can potentially add valuable diversification benefits to traditional stock-and-bond portfolios.
But this impressive growth has been accompanied by increased scrutiny, and not all investors have been thrilled by the performances delivered by exchange-traded commodity products. Most commodity ETPs maintain exposure to the underlying natural resources not by physically buying and storing the commodity, but by investing in futures contracts written on that particular asset. As such, these funds must “roll” their holdings as the expiration date approaches, lest they get stuck taking physical delivery of cattle, natural gas, or whatever other commodity in which they invest.
As such, the performance of commodity ETFs depends not only on changes in the spot prices, but on the slope of the futures curve and interest earned on uninvested cash as well. That has proven to be a tough concept for some investors to grasp, as evidenced by the complaints detailed in a recent BusinessWeek cover story. “Contango eats a fund’s seed corn, chewing away its value,” wrote Peter Robinson, after profiling the plight of investors who were apparently surprised when their investments in commodity products didn’t mimic spot prices [also read Five Things BusinessWeek Didn't Tell You About Commodity ETFs].
USCI: The Next Generation Of Commodity ETPs?
With more and more investors expressing frustration with the impact of contango on returns to exchange-traded commodity products, demand for a product that could address this issue was growing. When United States Commodity Funds, the issuer behind the ultra-popular United States Natural Gas Fund (UNG) and United States Oil Fund (USO), launched its first broad-based commodity product, USCI, it was quickly anointed as the “contango killer,” a fund that would eliminate return erosion once and for all. “US Commodity Launches Contango-Killer ETF” read a headline on Index Universe. Other experts reported (erroneously) that the index would remove commodities for which markets are contangoed [see Four Kinds Of Commodity ETFs].
USCI consists of 14 futures commodity contracts from a pool of 27 each month, using a complex screening methodology to make its selections. Don’t get me wrong, USCI is unlike anything the commodity ETF space has ever seen before, and the track record of the underlying methodology is certainly impressive. But contango is a tough dragon to slay, and printing the death certificate may be a bit premature.
The underlying index is perhaps more appropriately described as implementing a quant-based methodology. A computer-driven strategy focuses on dynamics that give clues to inventory levels, including relative prices between near-dated and far-dated futures contracts and one-year price momentum. By implementing these screens, the strategy favors commodities with low inventories, which, as Ian Salisbury notes, “are more prone to price spikes, and thus will produce better returns than conventional commodity indexes whose holdings reflect production or trading volumes.”
As Patricia Oey notes for Morningstar, the index selects from a pool of 27 potential contracts the seven that have the highest percentage price difference between the closest-to-expire contracts and the next-closest-to-expire contracts (in other words, those showing the steepest backwardation or most mild contango). It then also selects the seven commodity futures contracts from the remaining 20 with the greatest percentage price change of the closest-to-expiration futures contract from the price of the closest-to-expire futures contract from the year prior (in other words, the best-performing commodities over the last year).
Under The Hood
If a commodity futures market is backwardated, odds are that it will find its way into USCI. But a look at the underlying holdings of the fund show that it isn’t a strict contango-free zone. The market for soybean futures, which makes up a nice slug of USCI, is contangoed. Same thing for gold, lean hogs, and platinum: the futures curves for all of these commodities slope upwards, potentially creating some contangoed headwinds for investors. In addition, natural gas, the commodity that has given investors in UNG all sorts of heartburn, is a component of USCI as well. October NYMEX natural gas futures, which trade at a discount of about 8% to November contracts, account for about 4% of USCI’s assets (September 2011 contracts, still in the meaty part of that upward-sloping curve, account for another 2% or so). If that isn’t contango, we don’t know what is [also read How Contango Impacts ETFs].
Two things to make very clear: First, USCF, the issuer behind USCI (as well as UNG and USO), isn’t marketing the new fund as any sort of “contango killer.” According to the fund fact sheet, USCI’s objective is to reflect the daily changes in percentage terms of the SummerHaven Dynamic Commodity Index Total Return. It notes that the relevant benchmark is “comprised of 14 Futures Contracts that will be selected on a monthly basis from a list of 27 possible Futures Contracts” and that “is rules-based and rebalanced monthly based on observable price signals.” The word “contango” is only mentioned except within a more general discussion of risks associated with futures based strategies.
Second, it seems clear that there is something to the strategy behind USCI. According to the prospectus, the index would have delivered returns north of 20% during the last ten years–significantly higher than other widely-used commodity benchmarks. Moreover, there is an abundance of academic research supporting the basic philosophy behind the screening methodologies.
USCI represents a big step forward in the commodity ETF space, and is certainly an intriguing alternative to existing products out there. But investors who buy this fund thinking they’ve seen the last of contango may be disappointed. The lesson, as always, is to do your homework before investing [for more ETF insights, sign up for our free ETF newsletter].
Disclosure: No positions at time of writing.