Ultimate Guide To “Third Generation” Commodity ETPs

by on August 8, 2012 | Updated August 14, 2012 | ETFs Mentioned:

The introduction of commodity ETPs has opened up a previously difficult to reach corners of the market to investors of all walks. No need to open up a costly (and complex) futures trading account, as this asset class is now available with all of the benefits inherent to the exchange-traded product structure, including transparency, intraday liquidity and low expenses, as well as enhanced tax efficiencies. Thanks to ongoing innovation in the industry, investors can now tap into products with unique methodologies that strive to combat perhaps the greatest foe to any commodity investor: contango [see also Everything You Need To Know About Commodity ETFs].

Although offerings like the iPath Dow Jones-UBS Commodity Index TR ETN (DJP) still dominate the space in terms of assets underFile:ZeaMays.jpg management, a growing breed of innovative ETPs is quickly gaining traction as investors look for more creative ways to round out their exposure. Simply put, contango has become a major value-killer when it comes to these futures-based “first generation” products [see also Futures Free Commodity ETFdb Portfolio].

Funds that invest in futures contracts have an automated roll process to avoid delivery on the underlying contracts, so when a contract is about to reach expiration, the fund automatically sell out of the front month and buys into a future month. Frustrations arise when futures markets are contangoed, because this automated roll process will sell low and buy high, thereby erasing gains for investors and hurting bottom line returns. As such, contango is a major value-killer for buy-and-hold commodity investors who are looking to steer clear of this infamous phenomenon [see also What Is Contango?].

Luckily, there are now several “third generation” commodity ETPs to choose from; these innovative products employ unique roll methodologies that look to mitigate the adverse effects of contango [see Commodity Guru ETFdb Portfolio].

All of the funds profiled below separate themselves from traditional “first generation” commodity ETPs by maintaining the flexibility to shift resource weightings and roll exposure in response to movements in market prices, inventory levels and the slope of the futures curve:

Ticker ETP Structure Expense Ratio
USCI United States Commodity Index Fund Commodity Pool 0.95%
BCM iPath Pure Beta Broad Commodity Exchange-Traded Note 0.75%
BNPC BNP Paribas STREAM S&P Dynamic Roll Global Commodities Fund Commodity Pool 0.65%
BLND UBS DJ-UBS Commodity Index 2-4-6 Blended Futures ETN Exchange-Traded Note 0.70%
SBV iPath Pure Beta S&P GSCI-Weighted ETN Exchange-Traded Note 0.75%
DBC PowerShares DB Commodity Index Tracking Fund Commodity Pool 0.75%
UCI UBS E-TRACS UBS Bloomberg CMCI ETN  Exchange-Traded Note 0.65%
  • USCI: This fund features a dynamic basket of holdings that changes on a monthly basis based on observable price signals. It screens out commodities that show the most significant backwardation or moderate contango. USCI ensures diversification by allocating assets to each of the six commodity sectors (grains, softs, industrial metals, precious metals, agriculture and livestock) each and every month [see Commodity ETFs Counting On Contango].
  • BCM: This ETN uses a rules-based methodology consisting of four steps; first, the front year average price (FYAP) is calculated to measure the commodity’s economic value. Then, each futures contract is ranked based on how closely it tracks the FYAP. Next, contracts with insufficient trading volumes are filtered out as well as those subject to price distortions due to short-term supply and demand factors (such as weather conditions). Each month, BCM makes an allocation to one futures contract per commodity that it deems to be most representative of the returns for that particular good [see also Understanding Contango: Natural Gas Example].
  • BNPC: This fund will generally shift between near-dated futures contracts and longer-dated ones; when markets are in contango, the underlying index will consist of longer-dated contracts, thereby minimizing the roll frequency and mitigating the impact of contango on bottom line returns. On the flip side, when markets are backwardated, BNPC will tend to hold primarily front-month futures contracts [see also 5 Questions To Ask When Buying An ETF].
  • BLND: As the name suggests, this ETN holds a diversified portfolio of commodity futures contracts diversified across multiple maturities, including equal allocations to contracts that are two, four and six months out. From a portfolio composition perspective, like many other commodity ETPs, BLND is tilted towards the energy sector as it allocates roughly one-third of total assets to Brent, WTI crude, heating oil, natural gas and gasoline futures.
  • SBV: This ETN employs the same “Pure Beta” methodology as BCM, with the distinguishing factor being the underlying basket of holdings. BCM is incredibly well-balanced, offering fairly equal exposure across all six commodity families; SBV, on the other hand, is heavily tilted towards energy futures, offering up a risk-return profile that makes it less appealing for those interested in broad, balanced commodity exposure over the long haul [see also The Ten Commandments of Commodity Investing].
  • DBC: This is the oldest broad-based commodity ETF which incorporates a dynamic roll methodology. DBC employs what is known as the “Optimum Yield”; this roll process looks out 13 months on the futures curve and selects the contracts which are deemed to be the best in minimizing the negative effects of rolling futures contracts forward when a market is in contango and maximize the benefits of rolling when markets are in backwardation [see also "Optimum Yield" ETFs: A Contango-Free Alternative?].
  • UCI: This ETN holds a broad basket of 26 commodity futures contracts diversified across five constant maturities from three months up to three years. Unlike many commodity ETPs, this offering from UBS is not dominated by energy holdings; industrial metals and agricultural commodities also receive a substantial allocation in the underlying index.

Verdict

While each of ETPs profiled above seeks to deliver broad commodity exposure, they aren’t quite identical thanks to some structural differences as well as their unique roll methodologies. Each of the funds have potential advantages, ranging from cost and tax efficiencies to portfolio composition. Different funds will be more appropriate for different investors; the lesson, as always, is to do your homework before establishing a position. Our Special Research Report: In Search Of The Best Commodity ETP offers an excellent starting point for anyone looking to tap into the growing market of exchange-traded commodity products.

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Disclosure: No positions at time of writing. Photo courtesy of Christian Fischer.