The latest innovation in the commodity ETP space came from UBS on Thursday, as the company rolled out a pair of products designed to exploit contango in two of the most heavily-traded energy futures markets. The new ETRACS Natural Gas Futures Contango ETN (GASZ) and ETRACS Oil Futures Contango ETN (OILZ) will be linked to indexes maintained by ISE that effectively maintain short exposure to front month contracts and long exposure to mid-term futures contracts.
GASZ: Unique Natural Gas Exposure
This ETN seeks to replicate the ISE Natural Gas Futures Spread Index, which takes a 100% long position in the components of the ISE Short Front Month Natural Gas Futures Index (which provides inverse exposure to an index comprised of front month natural gas futures). That position is combined with an aggregate 100% long position in the the ISE Twelfth Month Natural Gas Futures Index, ISE Thirteenth Month Natural Gas Futures Index and ISE Fourteenth Natural Gas Futures Index (equal one-third positions in each benchmark). The underlying components of all the relevant indexes are Henry Hub natural gas futures contracts expiring in various months. The index will be rebalanced monthly to the 1:1 ratio [see all the ETFs tracking natural gas here].
OILZ: Oil ETP With A Twist
This ETN will be linked to the ISE Oil Futures Spread Index, which is designed to provide short exposure in front month oil futures contracts and long exposure in mid-term oil futures contracts. It does this by including a 100% long position in the ISE Short Front Month Oil Futures Index (which offers inverse exposure to a benchmark comprised of short-term oil futures) and an an aggregate 150% long position in the ISE Sixth Month Oil Futures Index, ISE Seventh Month Oil Futures Index and ISE Eighth Month Oil Futures Index (50% long position in each index). The underlying holdings of each index are Light Sweet Crude Oil Futures (WTI) contracts [see all the ETFs tracking crude oil here].
OILZ will also rebalance monthly to maintain the 1.5:1 ratio. Both ETNs will charge annual expenses of 0.85%.
Investment Thesis: Exploiting Contango
As interest in achieving commodity exposure through exchange-traded products has grown in recent years, investors have become aware of some of the nuances and potential limitations to the combination of this asset class and structure. While some commodity products invest in hard assets, most offer exposure by holding futures contracts. That strategy allows investors to access a wide variety of natural resources in a cost-efficient, low maintenance manner, but also means that commodity ETPs often won’t move in lock step with the spot prices of the underlying asset [use the free ETF screener to filter physically backed or futures-based commodity ETPs].
When markets are contangoed–meaning that long-dated futures contracts are more expensive than those approaching expiration, commodity ETPs will tend to lag behind the performance of a hypothetical investment in the spot resource. So while many commodity products are extremely useful tools for those looking to establish a relatively short term tactical position, they face some stiff headwinds when held in long-term portfolios [see Why Contango Matters: Natural Gas Example].
The popular United States Natural Gas Fund (UNG) serves as a good example. This product invests in front month natural gas futures, making it useful for those looking to make a play on natural gas prices. Since UNG debuted in April 2007, spot natural gas prices have declined by about 40%. UNG has lost closer to 90% of its value during that time period, the result of consistent contango in futures markets and a monthly roll schedule (it’s a similar story for oil ETFs):
The new ETRACS ETNs are essentially designed to exploit the structural nuances of futures markets. By taking a short position in an index comprised of short-term futures, these products have the potential to profit from the very phenomena that have caused the abysmal long-term performance in futures-based commodity products. The exposure to mid-term futures delivers exposure to the underlying energy commodity through a stretch of the future curve that generally experiences less severe contango. And by spreading that exposure across multiple months, the roll frequency is diminished [Commodity ETF Investing: Five Factors To Consider].
“We have seen the effects of contango and negative roll yield on the returns of futures-based commodity exchange traded products,” said Christopher Yeagley, Managing Director and US Head of Equity Structured Products. “Now investors have the opportunity to take advantage of the term structure for each of these respective futures markets, without taking a directional view in the underlying commodity.”
XVIX: Case Study
Late last year, UBS rolled out the ETRACS Daily Long-Short VIX ETN (XVIX), a product that takes a similar approach to volatility exposure. That ETN is linked to an index that combines a long 100% position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a short 50% position in the S&P 500 VIX Short-Term Futures Index Excess Return. That strategy is designed to give exposure to a unique asset class while also capitalizing on inefficiencies in the VIX futures market (which often exhibits steep contango at the short end of the maturity curve). There are some differences in the methodologies employed–XVIX rebalances daily, and maintains only a 50% short position in the short-term futures index–but the approaches are generally similar [Using ETFs To Access Alternatives].
The performance of XVIX might give an indication of the risk/return profile that can be expected of the new oil and gas ETNs. Since its inception, XVIX has exhibited relatively low volatility. The ETN has come close to breakeven since launch, while the iPath S&P 500 Short Term VIX ETN (VXX) has lost close to half of its value:
Disclosure: No positions at time of writing.