Commodity ETF Gamechanger: U.S. Commodity Index Fund (USCI) Launches

by on August 10, 2010 | ETFs Mentioned:

Over the past few years, the ETF market has grown exponentially as a variety of new funds have launched in numerous sectors. One of the segments that has seen the most growth has been the commodity space; dozens of new funds have sprung up targeting commodities ranging from corn to aluminum and everything in-between. However, as the sector has grown it has attracted a fair amount of unwanted attention from a host of institutions. Government regulators have taken a closer look at the nuances of many of these products, while various publications have focused on alleged flaws. The cover of BusinessWeek recently detailed the “Amber Waves of Pain,” digging into woe-is-me tales of investors who complained about losing money in commodity funds that were well beyond their understanding.

Much of the criticism of commodity products has focused on the impact of contango on total returns. Because most products utilize futures contracts to establish exposure to natural resources, the returns to these funds depend not only on changes in spot prices, but the slope of futures curves as well. BusinessWeek and others should be excited about the latest ETF to hit the market: a potentially contango-defying fund that could change the way investors think about commodity exposure.

Earlier today, U.S. Commodity Funds, the company responsible for the extremely popular United States Natural Gas Fund (UNG), announced its newest initiative in the commodity market: the United States Commodity Index Fund (USCI). The fund seeks to reflect the performance of a diverse group of commodities which are among the most important and liquid futures contracts in the world as well as a daily fixed income return reflective of the interest earned on a hypothetical 3-month U.S. Treasury Bill portfolio. This fund represents the first long-only active benchmark for commodity investors, determining its underlying holdings based on a unique methodology [also read What Every Investor Should Know About Commodity ETF Investing].

Under The Microscope

This new fund will track the SummerHaven Dynamic Commodity Index Total Return, a benchmark that will consist of 14 futures contracts that will be selected on a monthly basis from a list of 27 possible futures contracts. The index will be rules-based and rebalanced monthly based on observable price signals, meaning that the composition will be determined by quantitative formulas relating to the prices of the eligible futures contracts [also see Seven Funds Investors Want Now].

The index reflects resources in six commodity sectors: energy (e.g., crude oil, natural gas, heating oil, etc.), precious metals (e.g., gold, silver, platinum), industrial metals (e.g., zinc, nickel, aluminum, copper, etc.), grains (e.g., wheat, corn, soybeans, etc.), softs (e.g., sugar, cotton, coffee, cocoa), and livestock (e.g., live cattle, lean hogs, feeder cattle). As of last year, the fund was weighted heavily in industrial metals (28.6%), softs (21.4%), and precious metals (21.4%).

USCI is based on a simple but powerful investment thesis: historical data shows that portfolios comprised of commodities trading in backwardation tend to perform better than broad-based commodity baskets or commodities for which futures markets are contangoed. The idea behind USCI is that the optimal form of commodity exposure is achieved through positions in backwardated markets or markets that exhibit the least degree of contango [also see Optimum Yield ETFs: A Contango-Free Alternative?].

So USCI has the potential to eliminate some of the problems that have plagued UNG and other futures-based commodity products that have lagged far behind the hypothetical return on spot prices of the underlying commodity.

The cost for attempting to solve the contango conundrum is on the high side; the expense ratio comes in at 0.95%, one of the highest in the Commodity ETFdb Category. It’s also worth noting that since the fund is considered a partnership for U.S. income tax purposes, investors are required to report their gains on a schedule K-1; that could create some extra headaches for investors come tax time.

While it might not be perfect (or cheap), USCI is one of the most innovative commodity ETFs ever to hit the market, potentially offering investors a more efficient means of establishing exposure to non-correlated assets. Time will tell how the new ETF stacks up against the existing competition, but don’t be surprised it the new fund leaves the “first generation” of commodity ETFs in its dust [also read Five Things BusinessWeek Didn't Tell You About Commodity ETFs].

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Disclosure: No positions at time of writing.