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The Hidden Danger in Some ETFs
12/16/2010 12:01 am EST
As the ETF industry has grown and evolved, the product lineup has become increasingly sophisticated. Many of the products now hitting the market are designed to address issues posed by earlier indexed products as issuers strive to devise new strategies for accessing both traditional and exotic asset classes. A number of issuers, led by Schwab and Vanguard, have lowered costs on stock and bond funds, seeking to attract cost-conscious investors. Last week, Rydex rolled out a suite of equal-weighted equity ETFs that many investors believe are a more appealing option than cap-weighted funds. And in the commodity space, a number of issuers have introduced products that seek to address what some perceive as an oversized impact of “contango” on fund returns.
Contango occurs when longer-dated futures contracts are more expensive than those that are approaching expiration. In other words, the futures curve is upward-sloping. This may be the result of a number of factors, including market expectations, costs incurred in storing the underlying commodities, or inventory levels. Because exchange traded commodity products don’t want to take delivery of the commodities underlying each futures contracts, they must “roll” holdings on a regular basis, selling those that are approaching expiration and using the proceeds to purchase contracts that expire at some point in the future. When markets are contagoed, commodity ETFs will generally be forced to sell low and buy high, creating ongoing headwinds that must be overcome just to break even.
When the “roll yield” is incurred on a regular basis, the gap between a fund’s return and the hypothetical return on spot prices can become significant. As the commodity space has developed, a number of strategies designed to mitigate the undesirable effects of contango have been developed.
There are a handful of other options for fighting contango:
1. Maintain Spot Exposure
The simplest and most effective way to eliminate the effects of contango is to invest in the spot commodity. Because the underlying assets of physically-backed ETFs are the actual commodity, the net asset value (NAV) of these funds should always move in lock-step with the spot market price. The returns will be the same as if the investor had bought and stored the commodity, minus expenses.
The problem, of course, is that not all natural resources lend themselves to the physically-backed ETF structure. At present, the only US-listed ETFs that invest in physical commodities are those in the precious metals ETFdb category. Thanks to the high value-to-weight ratio of gold, silver, platinum, and palladium—as well as the physical properties of these metals—creating a fund that offers spot exposure to these metals is easy enough. But for cheaper commodities, such as many industrial metals, the costs of storage may become significant. And for many agricultural commodities, inevitable spoilage makes a physically-backed structure impractical (though constructing a physically-backed livestock ETF would be quite entertaining).
The first physically-backed industrial metal ETFs recently began trading in Europe, and multiple firms have filed for approval of physically-backed copper ETFs here in the US, meaning that options in this corner of the market could increase in the not-so-distant future.
2. Spreading Out Exposure
Because the “roll yield” associated with contango is incurred when exchange-traded funds must sell underlying holdings approaching expiration, it makes sense that those funds with the greatest turnover will generally feel the greatest impact of contango. Conversely, those that roll their holdings less frequently can potentially dampen the adverse impact.
The tradeoff from this approach comes in the sensitivity to changes in spot prices. In general, longer-dated futures contracts will be less sensitive to changes in spot commodity markets, meaning that funds that spread exposure beyond front-month futures will lag spot when prices are rising.
There are two primary approaches to spreading futures contract holdings over multiple months:
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2a. 12-Month Approach: There are a couple commodity ETFs that spread exposure across 12 different maturities, starting with the next to expire and including each of the next 11 contracts. These include cousins of the ultra-popular United States Gas Fund (UNG) and United States Oil Fund (USO), the United States 12-Month Natural Gas Fund (UNL) and United States 12-Month Oil Fund (USL). These funds roll only a fraction of their holdings every month, limiting turnover relative to funds that swap out their entire asset base 12 times each year.
This might seem like a light shift, but the impact on returns can be significant. Since its launch in 2007, USL has beaten USO by more than 25%:
2b. The “Teucrium” Approach: Oil and natural gas futures are unique in that there are contracts expiring each month. For most commodities, futures expire four or five times a year, meaning that balancing exposure across 12 different maturities would require significant holdings in some very long-dated contracts, which can be illiquid.
Teucrium utilizes a modified version of this approach for its Teucrium Corn Fund (CORN), splitting exposure between the second-to-expire CBOT corn futures contract (35%), the third-to-expire CBOT corn futures contract (30%), and the CBOT corn futures contract expiring in the December following the expiration month of the third-to-expire contract (35%).
CORN is the only product on the market now that implements this strategy, but the company has filed for a number of additional commodity products that could hit the market sometime in 2011.
3. Optimum Yield
In addition to the options presented above, the commodity products offered by PowerShares and Deutsche Bank take a unique approach to minimizing the adverse impact of contango on fund returns. Many of the commodity products offered by this partnership are linked to “optimum-yield” versions of Deutsche Bank indexes, which are designed to minimize the negative effects of rolling futures contracts when a market is in contango and maximize the benefits of rolling when markets are in backwardation.
This approach has more flexibility than those outlined above, as the composition of the index is determined based on observable price signals and a proprietary methodology. For example, the PowerShares DB Commodity Index Fund (DBC), which seeks to replicate the Deutsche Bank Liquid Commodity Index—Optimum Yield Diversified Excess Return, recently included brent crude contracts expiring in January, zinc contracts expiring in May, and silver futures expiring next December.
In addition to the broad-based DBC, there are a handful of resource-specific funds linked to optimum-yield versions of commodity indexes.
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4. “Contango Killer” ETF
One of the most innovative products to hit the market this year is the United States Commodity Index Fund (USCI), which has been described as both a “contango killer” and a “third generation” commodity ETF. USCI isn’t actively managed, but rather seeks to replicate the performance of a commodity benchmark that rebalances monthly based on various pricing factors.
The composition of the underlying index is basically determined based on two criteria. First, from a universe of 27 potential components, the seven exhibiting the steepest “backwardation” or most moderate contango are selected for inclusion. The remaining commodities are then ranked by price increase over the past year, regardless of whether the related futures market is “backwardated” or contangoed. The seven commodities with the best performance over the last year are included to round out the index. The manner in which this strategy softens contango should be obvious, though it is worth noting that the “momentum screen” may allow for inclusion of commodities for which the futures curve slopes upward.
The idea behind the fund is not that “backwardation” leads to strong performance, but rather that tight physical inventories are often associated with price appreciation. Based on thorough research done by a team that includes Yale professors K. Geert Rouwenhorst and Gary Gorton, there is evidence to suggest that the slope of the futures curve can provide some insights into inventory levels. “This is something that follows from economic theory, in particular the theory of storage,” says Rouwenhorst. “When inventories are low, users of commodities may be willing to pay a premium for owning a spot commodity relative to futures prices in order to avoid facing a ’stock out.’ You can only heat your building with physical heating oil, not futures on heating oil. So when inventories are low, you are willing to pay a premium to own spot heating oil to avoid the risk of running out. This premium is sometimes called the convenience yield, and can lead to a backwardated futures curve.”
USCI is relatively new, so it is perhaps too early to declare it as a superior means of accessing commodities. But the early returns have certainly been impressive. Since debuting in August, USCI has gained about 21%. Over the same period, the aforementioned DBC (which has more than $5 billion in assets) has gained a more modest 14%.
By Michael Johnston of ETFdb.comSee more articles about contango at ETFdb.com
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