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:
- 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.
- There is only $5 million in the ETF right now, and it launched a few days ago.
- Ironically, if it became wildly popular this index could be front-runned as well. (front-ran?)
- We don’t know how tight the premia and discounts to NAV will be (how good the market makers are).
- 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.
- Given that commodities have been shown to do well in the past, is the party over? Is there a new market equilibrium for commodities?
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.