Commodity ETPs can be extremely powerful tools for tapping into an asset class capable of providing both return enhancement and diversification benefits. With dozens of products available–there are more than 120 U.S.-listed commodity ETFs according to the ETF screener–picking the right fund for your investment objectives and risk tolerances can be challenging. Beyond the type of commodity included, there can be several attributes of commodity ETPs that shape the risk/return profile; below, we look at five factors to consider when trying to narrow down the universe and find the right commodity ETF (or ETN):
1. Structure: ETC vs. ETN
Most investors are familiar with the various product structures that are generally lumped together under the ETF umbrella, including exchange-traded notes, HOLDRs, and UITs. While the fine print of various security types may seem like inconsequential details, the nuances can have a meaningful impact on bottom line returns–especially in the commodity space.
Generally, the trade-offs between ETFs and ETNs relate to credit risk and tracking error. Because ETNs are debt instruments, investors are exposed to the credit risk of the issuing institution. If the bank that issued the debt goes belly up, holders of ETNs get in line with the rest of the creditors. ETF investors don’t face that risk; there’s a protective wall between the issuer’s accounts and the ETF assets.
Offsetting that drawback of ETNs is the elimination of tracking error. Unlike ETFs, ETNs don’t actually maintain a portfolio of underlying securities; the return is simply calculated based on the change in value of a hypothetical index. That means that ETNs don’t have to buy and sell securities in order to mimic an index, requirements that can be recurring sources of tracking error when holdings must be “rolled” as underlying contracts approach expiration (as is the case with the holdings of many commodity ETPs).
Consider the example of the iShares S&P GSCI Commodity-Indexed Trust (GSG) and the iPath S&P GSCI Total Return ETN (GSP), both of which are linked to the S&P GSCI Total Return Index. Through the first five months of 2011, GSP had gained about 8.0%–roughly 160 basis points more than the iShares product linked to the same index.
ETF investors generally attribute little value to the “tracking error avoidance” features of ETNs. And in most cases, they’re right; most ETFs are run so efficiently that tracking error is a very minor concern. But when the portfolio turnover is so high–it has to be in order to avoid taking physical delivery of the underlying natural resources–this feature of exchange-traded notes can truly shine.
Taxation of commodity products is a complex topic, and the exact treatments may vary from investor to investor. But it’s important to note that the structure of various commodity products can have a direct impact on future tax obligations. More than a few investors have been surprised to find out that they owe taxes on a futures-based exchange-traded commodity product, the result of some unique regulations.
Commodity ETFs that are structured as limited partnerships (LPs) and achieve exposure through futures contracts, such as DBC or USO, incur taxes on an annual basis, even if the position was not liquidated. The applicable capital gains are calculated at a blended rate: long-term rates weighted 60% and short term-rates weighted 40%. When held in a taxable account (it may not be an issue in an IRA), it can be frustrating to rack up a tax bill without closing out a position. If commodity prices skyrocket and the ETF delivers a big gain, investors may find themselves facing a big liability to cover tax obligations.
ETNs, on the other hand, are debt instruments issued by financial institutions. Unlike ETFs, they hold no assets; instead, the value fluctuates based on performance of the underlying index. With commodity ETNs, there is no tax liability incurred until the position is closed out, making this structure potentially advantageous for those wanting to establish exposure to natural resources for the long-term.
2. Commodity Mix
Investors looking for broad-based exposure to natural resources–whether through an ETF or ETN–have no shortage of options. There are about 14 products in the Commodities ETFdb Category that seek to replicate indexes comprised of various types of commodity futures. And while there are some similarities between these products, there can be some rather significant differences as well. Often, ETPs that include exposure to the same types of commodities will have very different risk/return profiles–a result of the unique mixes of exposure across different commodity “families.”
Some commodity ETPs have a heavy allocation to energy resources such as natural gas and crude oil. The aforementioned GSG and GSP fall into this bucket; the index to which those products are linked consists of nearly 70% energy commodities; the remainder is spread across agriculture (16%), industrial metals (8%), livestock (4%), and precious metals (a paltry 3%).
Other commodity indexes have significantly higher allocations to agricultural commodities and precious metals such as gold and silver. The GreenHaven Continuous Commodity Index Fund (GCC), for example, includes a much smaller weighting to energy commodities (replaced with a heftier allocation to agricultural resources). So for investors particularly bullish on energy resources GSG might make the most sense, while those who expect rising food prices may gravitate towards GCC [see How Balanced Is Your Commodity ETF?].
A quick example illustrates the impact of the commodity mix on bottom line returns. Both the PowerShares DB Commodity Index Tracking Fund (DBC) and E-TRACS Dow Jones-UBS Commodity Index Total Return ETN (DJCI) include exposure to aluminum, copper, corn, gold, heating oil, light crude, natural gas, RBOB gasoline, silver, soybeans, sugar, wheat, and zinc. But the weights afforded to each of these commodities varies between the funds, and DJCI also includes a handful of other commodities (such as coffee, cotton, live cattle, and lean hogs). Through May, DBC was up about 9.8% on the year while DJCI had gained about 2.9% year-to-date. The breadth of the commodity exposure and mix of the included resources has made a difference of about 700 basis points so far in 2011, illustrating the potential impact of the distinction between products that may seem similar on a portfolio’s bottom line.
3. Roll Frequency
Most investors are aware by now that the majority of commodity products offer exposure not to movements in spot prices of the related natural resource, but to a futures-based strategy that is also impacted by the degree of contango or backwardation present in futures markets.
For many commodities, there are multiple ETP options out there that are distinguished by the frequency with which they “roll” the underlying holdings; some turn over their entire portfolio monthly, while others will trade far less frequently. Consider the universe of natural gas ETPs:
- United States Natural Gas Fund (UNG): Holds front-month contracts, rolling on a monthly basis
- United States 12 Month Natural Gas Fund (UNL): Spreads exposure across 12 months, rolling only a small portion of its portfolio monthly
- Terucrium Natural Gas Fund (NAGS): Spreads holdings across four maturities, including the the nearest to spot month March, April, October and November contracts
- iPath Seasonal Natural Gas ETN (DCNG): Linked to an index consisting of the December natural gas contract, rolling only one time per year.
While all of these funds offer exposure to natural gas futures, they are far from identical; the structure of the underlying futures contracts can have a material impact on bottom line returns. Consider the performance of these funds during the months of April and May:
- UNG: +2.5%
- UNL: +0.8%
- NAGS: -1.8%
There is no universally superior methodology for spreading holdings across the futures curve. Investors making a short-term play will generally prefer front month products such as UNG, since the sensitivity to movements in spot prices in greater. Those looking to express a longer-term view will likely gravitate towards a fund such as NAGS designed to mitigate the impact of contango. But the decision of how frequently to roll holdings and how to spread exposure across the futures curve is an important one that can potentially have a big impact on bottom line returns.
4. Expenses: Big Gaps Are Sometime Illusions (But Sometimes Not)
Some investors making the switch to ETFs pat themselves on the back for embracing what they’ve heard are low cost vehicles, and assume that all ETFs are equally tax efficient. In reality, the gap between ETFs that offers similar or even identical exposure can be wide enough to drive a truck through–especially in the commodity space.
Gold ETFs are one such example; the Gold SPDR (GLD) charges 0.40% in annual fees, significantly more than the iShares COMEX Gold Trust (IAU) that has an expense ratio of 0.25%. The underlying assets of both funds are gold bars stored in secure vaults; while there are some nuanced differences between the two, the expense gap is the most glaring differential.
Another big expense ratio delta exists between two ETNs linked to the broad-based Dow Jones-UBS Commodity Index Total Return; DJP charges 0.75%, while DJCI costs just 0.50%.
Investors who are willing to dig around can save themselves a few basis points when it comes to commodity exposure, which can translate into big dollar savings over the long run.
Apples To Oranges
Investors who are diligent about analyzing expenses should be certain that they’re comparing apples to apples–which is sometimes not so straightforward in the commodity space. It’s important to understand all the components that go into the bottom line expense ratio; when it comes to commodity ETFs, this includes a lot more than just the management fee.
To demonstrate the potential confusion, we’ll examine two of the natural gas ETFs highlighted above. Investors examining the expense issue may notice that UNG charges a management expense ratio of 0.60%, while the expense ratio for NAGS is 1.58%. That’s a huge gap in fees, but the two figures aren’t apples-to-apples.
Commodity ETFs incur fees every time they “roll” the underlying holdings, a process that generally involves selling contracts approaching expiration and purchasing longer-dated futures. These fees are generally borne by investors in the fund, and can end up making a meaningful contribution to bottom line expenses. In 2010, UNG paid/accrued about $18.9 million in portfolio brokerage commissions, and another $11.6 million in other fees. Those amounts translated to about 0.29% and 0.17% of net assets, respectively, and bring the total “all-in” expense ratio for the fund to about 1.0%. That gives us a figure that can be compared to NAGS bottom line expense ratio of 1.56% (and trims the gap between the two considerably).
5. Watch For Premiums / Discounts
When considering a position in any exchange-traded product, it makes sense to always search for the presence of a premium or discount. But this part of the research process is especially important for commodity ETPs, as position limits have the potential to create big gaps between a product’s price and NAV.
The iPath Natural Gas ETN (GAZ) serves as a cautionary tale. This product is linked to an index comprised of natural gas futures, and in 2009 elected to suspend the creation of new shares in the ETN, citing “current market dynamics and ongoing regulatory review.” That decision effectively neutralized the creation/redemption mechanism that keeps prices in line with NAV, and GAZ has regularly traded in a wide band [see Strange Times For GAZ].
So far in 2011, the premium to NAV for GAZ has ranged from 0% to about 20%, a huge range:
When commodity ETPs deviate from NAV regularly, additional risk factors are introduced. The added uncertainty can work both for and against investors; for example, an investor who bought into GAZ at the beginning of February and sold at the and of March would have netted a profit of about 9%, even though the note’s indicative value declined by about 4% during that period (the inflation of the premium more than offset the decline in natural gas prices). Conversely, an investor who bought GAZ at the end of March and held for two months would have lost about 6%, even though the IV increased by about 3% over that period (the deflation of the premium provided stiff headwinds).
Disclosure: No positions at time of writing.