The rise of the ETF industry has changed the way many approach investing. The rock-bottom expense ratios charged by many ETFs have sparked a closer look at the merits of active management and a more critical look at the fees charged by traditional actively-managed mutual funds (see The True Cost Of Active Management). The ability to trade intraday has lured active traders away from individual stocks and into broad-based ETFs and more targeted sector funds. And the new-found accessibility of commodities through exchange-traded products has altered the asset allocation process and presented new options for non-correlated assets.
While many of the ETFs available in the U.S. have seen increased interest in recent years, the growth of commodity products has been particularly impressive. In 2009, commodity ETFs took in cash inflows of more than $30 billion. But there have been some growing pains along the way. Because the value-to-weight ratios and physical properties of most commodities (with the exception of precious metals) make exposure to spot prices through physical storage either impractical or prohibitively expensive, many exchange-traded commodity products rely on a futures-based strategy to achieve exposure.
While these funds will generally exhibit a strong correlation with spot commodity prices, the returns will also be impacted by the slope of the futures curve. When markets are in contango, returns to futures-based ETFs can lag the hypothetical returns on spot prices by a wide margin. The nuances of a futures-based strategy are generally straightforward, but they are still lost on certain investors. Some accused the United States Natural Gas Fund (UNG) of being a flawed product in 2009 when it lost nearly half of its value. It isn’t, but because the holdings of UNG are primarily futures contracts (not natural gas), last year’s environment produced less-than-desirable returns (see How UNG Lost 20% In March).
Cash flows to commodity ETFs have slowed considerably, with one potential explanation being a frustration with the “uphill climb” associated with an investment in futures-based products (see Three ETFs That Could Be Crippled By Contango). Many exchange-traded commodities invest primarily in front-month futures contracts, meaning that holdings must be “rolled” on a monthly basis to avoid taking possession of the underlying. In addition to creating a regular opportunity to incur a “roll yield,” this strategy allows other traders to front-run the yield process, potentially impacting the efficiency of the fund.
An Interesting Alternative
For investors frustrated with the behavior of commodity ETFs, it’s important to realize that not all futures-based indexes are created equal. While many roll their holdings at predetermined dates, others utilize a more complex strategy designed to generate the maximum possible returns. PowerShares and Deutsche Bank have teamed up on a line of commodity products linked to “Optimum Yield” indexes that present an interesting alternative.
The Optimum Yield version of these indexes seeks to replace expiring futures contracts with new contracts expiring in the month that will generate the highest “implied roll yield.” The exact methodology for determining which contracts to buy when is somewhat complex, but the goal of this strategy is relatively simple: minimizing the negative effects when markets are in contango and maximizing the positive effects when markets are backwardated.
A quick look at the major holdings of DBC highlights the nuances of the Optimum Yield strategy; the maturity dates of futures contracts are scattered, ranging from zinc futures expiring in May to copper futures expiring in March 2011. The holdings of several single-commodity Optimum yields are interesting as well; DGL is currently invested in October gold futures, DBS owns December silver futures, and DBO holds July crude oil contracts.
Currently, there are a number of commodity products linked to Optimum Yield benchmarks, including:
To find all of the Optimum Yield ETFs (including inverse and leveraged ETFs), investors can use this ETF Screener to filter commodity products by the underlying index.
While all of these products are passively-indexes exchange-traded products, they incorporate elements of active management that some believe is extremely important in the commodity space: analyzing the futures curve to determine the most efficient roll points.
Of course, the strategy implemented by these products isn’t guaranteed to outperform either spot prices or simpler strategies that call for rolls to occur at predetermined times. But for investors looking for a new way to establish exposure to commodities, the Optimum Yield products might be worth a closer look.
Disclosure: No positions at time of writing.