Though the entire ETF industry has grown at a blistering pace, certain segments of the market have expanded much more quickly than others over the past few years. Few types of financial products have seen stronger asset growth than commodity ETPs, as investors of all sophistication levels have embraced the exchange-traded structure as the most efficient means of accessing an asset class that has become increasingly popular as a source of both diversification benefits and return enhancement. And one of the most exciting new product introductions in this corner of the market came about a year ago when United States Commodity Funds rolled out USCI, a fund dubbed by many as a “contango killer.”
Billions of dollars have flowed into commodity ETPs in recent years, as nearly every type of natural resource has delivered sharp increases in price thanks to rising demand for raw materials from many of the world’s emerging markets. But despite generally stellar returns, some investors have expressed frustration with the performance of commodity ETFs and ETNs. The source of this frustration relates primarily to the manner in which many of these products achieve their exposure; although a handful of precious metals ETFs are physically backed by bullion, most commodity ETPs utilize futures contracts to deliver exposure to the underlying natural resource. While that approach is logical–holding a farmyard full of livestock or pipelines full of natural gas would be both a logistical nightmare and prohibitively expensive–it introduces some additional risk factors to the equation.
Futures based commodity strategies depend not only on the movements in the spot price of the natural resource, but also on the slope of the futures curve and the frequency of the “roll” of futures contracts (and, when rates aren’t scraping zero, on the interest earned on any uninvested cash). When futures curves slope steeply upwards and funds roll holdings on a frequent basis, the impact of this second factor can be significant, resulting in big gaps between a hypothetical return on a spot commodity investment and the performance of the ETP linked to that resource [see Contango's Crush Explained]. The “erosion” of returns related to a contangoed market is simply a part of commodity investing–but a part that many wish they could avoid.
USCI’s First Year
USCI was introduced in August 2010 as a new tool for achieving broad-based commodity exposure. Instead of utilizing a predetermined basket of futures contracts, the index to which the ETF is linked utilizes certain screens to identify a basket of resources. The factors used to determine the portfolio include both momentum-based metrics and a measure of the severity of contango or backwardation in the related futures market. To simplify the methodology, USCI tends to tilt exposure towards commodities that have backwardation-related tailwinds at their backs, and away from those flying into contango-induced headwinds. From a universe of 27 potential commodities, 14 are included in any given month in the USCI basket [see more on USCI's Fact Sheet].
At the time of its launch, the strategies and investment thesis behind USCI were certainly compelling; investors were pleased at the development of a new means of accessing an asset class that had been climbing steadily higher and was making its way into more and more portfolios. There exists ample historical evidence suggesting that the USCI approach is capable of generating excess returns relative to more traditional commodity strategies. Now, with a year of live history, it’s easier to compare the performance of this fund relative to other popular commodity strategies.
USCI came flying out of the gates, jumping nearly 40% during its first six months of trading as the broad-based commodity rally continued to gain steam. More impressively, USCI crushed competing commodity ETFs during the run-up. During its first six months, USCI beat the PowerShares DB Commodity Index Tracking Fund (DBC) by about 14%, and outpaced the Dow Jones-UBS Commodity Index ETN (DJP) by an even more impressive 16%:
After creating a huge gap to the competition, USCI struggled a bit during its second six months as some of the wind came out of the sails of the commodity rally. As natural resource prices fell, USCI’s decline was more severe than other more broad-based commodity ETFs:
Though USCI has come back to the pack in recent months, the “contango killing” commodity ETF still finished its first year with an edge over more established and more popular products (DBC and DJP have close to $10 billion in aggregate assets). Between August 10th of 2010 and the same date of 2011, USCI had gained about 23%, putting it 100 basis points or so ahead of DBC and nearly 800 ahead of DJP [also see A Closer Look At The Next Generation Commodity ETF].
So is USCI a better way to add commodity exposure to your ETF portfolio? The jury may still be out on that issue, but the track record over the first year shows that the nuances between various commodity ETPs has a very serious impact on the bottom line returns realized as well as the volatility [see Commodity ETFs: Five Factors To Consider]
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Disclosure: No positions at time of writing.