[This article appears in our May issue of ETF Report.]
Commodity indexes, and the ETFs that track them, have come a long way since they were launched a few decades ago.
The very first commodity index, the CRB—also known as the Thomson Reuters/CoreCommodity CRB Index—was created in 1957 for participants in the agricultural futures markets. But commodity indexes weren’t really accessible to noncommodity investors. One of the reasons S&P took over ownership of the GSCI (first created by Goldman Sachs in 1991) in 2007 was to open commodities to institutional and retail investors, says Fiona Boal, global head of commodities at S&P Dow Jones Indices.
The main S&P GSCI still exists, and from that seed grew thousands of other commodity indexes and index providers—S&P alone says it has more than 6,000 commodity indexes. Some indexes focus on commodity sectors, some on specific commodities, some address seasonality themes and other quirks of the asset class. But the users are still largely institutional, with some retail business thrown in.
Assets under management for commodity ETFs compared to the total U.S. ETF universe are a pittance—at $66.7 billion versus nearly $4 trillion, respectively. That could change, especially if some of the economic forces that help commodities, namely inflation, come into play.
Avoiding Yield Drag
Boal says a lot of what today’s commodity indexes do is try to address roll yield, which can often be a performance drag. This was a significant issue for early commodity ETF investors.
“The biggest challenge that [ETF providers] face … is understanding roll yield in commodities,” Boal said. “Not just [that providers] understand it as an institution, but actually being able to educate the end investor about it.”
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Yield drag occurs when indexes roll positions from the front month to the next trading month, and are usually selling a cheaper position and buying a more expensive one. That happens because commodity markets are often in contango, when the front-month contract is cheaper than deferred contracts, in order to encourage storing the commodity (which is also why commodities are cited as inflation hedges).
When front-month prices are higher than deferred contracts, it’s called backwardation, and that occurs when there’s strong current demand. This situation is rarer, but that’s the position most natural resource markets were in during 2007, when many of the commodity ETFs launched.
“Contango and backwardation … are not concepts that make a lot of intuitive sense,” Boal said.
Many commodity indexes now try some sort of dynamic roll yield, which uses algorithms to choose the optimum contract rather than simply buying the next calendar month. Jason Bloom, director of global macro ETF strategy at Invesco, says PowerShares (now part of Invesco) started to look at ways to optimize the roll-yield process when yield drag in ETFs was becoming apparent.
For its funds, Invesco evaluates each commodity by calculating the annualized roll yield, and then buys the most optimum contract to minimize roll yield (not necessarily the next contract month). The contract is held almost to expiration, when they recalculate to choose the next month. That helps to address unique characteristics of each commodity, Bloom says.
“Energy commodity curves tend to be somewhat smooth—upward sloping, downward sloping—although they can have kinks in them,” he noted. “In agricultural commodities, you tend to get very seasonal curves that look like sine waves.”
There are also indexes that weight commodities differently, or have narrower focuses, such as just precious metals or just agricultural. The S&P GSCI has a much heavier energy weighting, while the Bloomberg Commodity Index weighting includes more agricultural and precious/industrial metal commodities.
Bloom says that, for ETF issuers, the weighting can make a difference: Too much agricultural products can soften the impact of commodities as an inflation hedge, while more energy or industrial metals can increase it.
The methodologies behind how to construct an index like the S&P GSCI doesn’t change, Boal says, but what’s in the indexes might. She points out that Brent crude oil, which has the biggest weight in the index now, wasn’t in the 1991 original index because the contract hadn’t been launched yet.
Commodities come in and out of indexes based on economic relevance, Bloom notes. Invesco gets a lot of requests for rare-earth ETFs, but without a liquid, standardized futures contract, the firm doesn’t feel an ETF would be appropriate to create.
There’s a move to develop strategies allowing people to take advantage of some of the underlying structural components, such as risk premia and factor-type investing, Boal says.
“Commodities can be very well-suited to strategies like momentum and carry,” she explained. “Carry is a real thing in commodity markets. You really can buy a barrel of oil today and sell it in three months’ time. So I think there are really exciting things to do in terms of risk premia commodity indexes.”
Brandon Rakszawski, director of ETF product development at VanEck, says most commodity products are still being used by institutional traders, especially after investors of all sizes were burned during 2008’s market crash.
“2008 was a difficult experience for a lot of investors who were either chasing returns or were trying to diversify a portfolio and look for uncorrelated assets,” he explained. “At the time, everything correlated in a way. Commodities just happened to fall further than a lot of other markets.”
Sal Gilbertie, founder of Teucrium Funds, issuer of agricultural ETFs, says the new generation of ETFs that dynamically address roll yield, or allow for long-term trading, have been vast improvements. But he adds that that first generation of ETFs “actually did a lot of structural damage,” keeping people away from commodity ETFs. Some of that sentiment lingers today, with trading platforms not wanting to carry ETFs based on derivatives, Gilbertie notes.
Rakszawski concurs that a lot of individual investors haven’t gotten back into commodities; much of the business stems from institutions that see commodities having a place in a traditional asset allocation model.
He says that, aside from precious metal ETFs like the SDPR Gold Trust (GLD) or the iShares Gold Trust (IAU), commodities’ AUM is small. Of the $66.7 billion in 125 U.S. commodities-based ETFs, $32 billion is in GLD. Rakszawski notes tax issues are another factor, since commodity-pool ETFs issue K-1 tax forms rather than 1099s, which can cause investors headaches. A few commodity ETFs are starting to address the tax issue to structure the funds so as to avoid K-1s.
Bloom says he started to see some financial advisors returning during 2017’s synchronized global growth, a weaker dollar and a pickup in Consumer Price Index growth. That’s when some individual financial advisors looked at commodities as a way to get direct exposure to rising inflation. “People started realizing, ‘Hey, commodities are cyclical,’” he said.
Boal notes that because commodities are still not well-understood by people familiar with equity or fixed-income investing, S&P is developing commodity indexes that embed a covered-call option strategy, which, at certain periods, allow the holder to take an income stream. That’s unusual for commodities, since they usually don’t generate income, and that might help attract investors.
“We’re really moving toward a lot of products that would be similar to the sorts of things you see in the equity and fixed-income markets,” she added, “but also products that allow you to capture some of those very unique risks that are apparent in the underlying commodity markets.”