The Contango Killing Commodity ETF

Canadian Capitalist recently discussed the negative drag on commodity futures ETFs caused by contango (also known as negative roll yield).  This is a specific contango that exists due to front-running of the ETFs.

The Contango Killing Commodity ETF

Ironically, two days later a new ETF was launched (these things are like tribbles these days!) which was designed to counteract the contango-drag. The ETF in question is USCI (United States Commodity Index Fund, trades on NYSE Archipelago). The goal is to track the SummerHaven Dynamic Commodity Index Total Return less expenses. This index skews towards longer term contracts and commodity futures in backwardation (opposite of contango, and also referred to as positive roll-yield).

What Is The Index Methodology?

There is a basket of 27 eligible commodity futures for inclusion. The index is rebalanced monthly to include 14 of those 27 constituents. 7 are selected based on the highest positive roll yield. The other 7 are selected based on the highest one year momentum (highest price change). The 14 constituents are then equal weighted.

Should You Care?

As with many new products, it’s best to take a wait and see approach before diving in, in my humble opinion. Beyond that, let’s look at the following factors:

  1. The index is designed to essentially cancel out the contango drag by introducing a backwardation headwind. By selecting 7 components with the most momentum, they are more likely to be in contango. Selecting the 7 components with the highest positive roll yield (backwardation) will tend to counteract this. With the index rebalancing monthly, this essentially provides  a long position in a basket of commodities while minimizing the contango drag. You will have different commodity exposures every month though.
  2. There is only $5 million in the ETF right now, and it launched a few days ago.
  3. Ironically, if it became wildly popular this index could be front-runned as well. (front-ran?)
  4. We don’t know how tight the premia and discounts to NAV will be (how good the market makers are).
  5. Most people probably don’t know how much commodity exposure they have in their portfolios currently, so how do you know if you need more (or less)? Consider all the stocks you may own in companies involved in exploration, mining, development, etc. of commodities.
  6. Given that commodities have been shown to do well in the past, is the party over? Is there a new market equilibrium for commodities?

Conclusion

I don’t own any direct commodity plays in my portfolio. I feel I have plenty enough through the companies in my index funds that are involved in commodities. Nothing about this new ETF really stands out to make me change that, but the ETF itself does attempt to solve the contango problem. If you have your heart set on direct, long term commodity exposure, you may want to keep an eye on this ETF for a year or two to see how it plays out in practice. For now: avoid.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 17 comments
  • Andy R

    Can a tribble be killed with a titanium spork ?
    How do you stop a runaway ETF?
    Does it really takes two to contango?

    Who knew investing could present so many questions!

  • Returns Reaper

    Preet,

    I too am skeptical of new products like these. I am also somewhat skeptical of commodities as an asset class, although it’s something I’ve been looking into recently and I’ve been mulling over whether or not to include a component of direct commodities exposure into my portfoliio (I currently have no direct exposure at all).

    I believe that a “good” asset class in a portfolio is one that has at least one (preferably both) of the following:
    a) low correlation to other asset classes in the portfolio
    b) has an expectation to increase in value over time

    However, I’d argue that if you believe that commodities are a good asset class, is it not potentially beneficial to include a direct commodities play in your portfolio? If other commodities exposure is tied into, for example, a large cap index, then having a pure commodities asset could be beneficial as it would allow you to rebalance only the commodities position.

    I guess my argument boils down to not simply deciding a priori how much exposure you want to different asset classes, but also providing some direct exposure to various asset classes so that as the asset classes move relative to each other, they can be rebalanced to provide a better overall return than the weighted sum of the individual components. I agree that as you do this, you want to make sure that your portfolio doesn’t become dominated by a particular asset class or market sector such that a large movement in the asset class or market sector would seriously impact your portfolio.

  • Returns Reaper

    Commodities seems to be a hot topic in the blogosphere as of late. Just after posting my comment, I read this blog post from Larry Swedroe:
    http://moneywatch.bnet.com/investing/blog/wise-investing/how-commodities-affect-a-portfolio/1608/

    It tackles whether or not to include direct commodities exposure based on the returns of the overall portfolio. The problem becomes how to get exposure to a commodities index. If the commodities products out there remain faced with contango-drag for long periods of time, I assume they don’t do a good job of tracking their target index.

  • Canadian Capitalist

    Thanks for the mention Preet. These days if you blink you’ll miss three new ETF announcements.

    I’m also staying away from commodities. The big reason is that a Canadian index already has massive exposure to the commodity sector through equities. I haven’t seen a study on whether Canadian investors should add commodities. For that reason, I’m on the sidelines as far as commodities are concerned.

  • larry macdonald

    I second Canadian Capitalist. Given their already high commodity exposure, Canadians don’t have to be as concerned about adding commodities to their portfolios as U.S or European investors. Also, the correlation between stocks and commodities appears to have climbed in recent years as the popularity of seeking diversification in commodities increases. So not sure if even for US and European investors, the diversification benefits are all that great.

  • Denise

    Thanks for sharing. Interesting article.

  • nursing schools

    Terrific work! This is the type of information that should be shared around the web. Shame on the search engines for not positioning this post higher!

  • RobertB

    Ironically, if it became wildly popular this index could be front-runned as well. (front-ran?)

    That would be front-run.

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