The Front-Month ETF Fallacy

March 06, 2012

If you’re still holding a commodities ETF that invests in front-month futures, it’s time to upgrade.

Two major variables are predictors of commodity index returns: commodity weights and futures contract selection.

The major commodities indexes—the Deutsche Bank Liquid Commodities Index (DBLCI), Dow Jones-UBS Commodities Index (DJCI), S&P GSCI Index (GSCI), Thomson Reuters Equal Weight Continuous Commodities Index (CCI), SummerHaven Dynamic Commodity Index (SDCI) and the Rogers International Commodity Index (RICI)—all have wildly different portfolios.

Commodity Index Table

While these differences are stark and obviously play a significant role in determining returns, the method of choosing and rolling futures contracts can play as big, or even a bigger, role in driving returns—especially in energy-heavy indexes like the GSCI that tend to have a large percentage of their portfolio in commodities that are in contango.

When a commodity is in contango, the price of the current futures contract is less than the price of the next-month futures contract, meaning you lose money when your exposure is rolled from an expiring current futures contract into the one that expires in the following month.

Generally, the cost of rolling exposure varies across different contract maturities.

Soybean futures contracts, for example, are in contango in the near term, but in backwardation further down the curve. Backwardation, the opposite of contango, occurs when the contract that you roll into is cheaper than the contract that you currently hold, allowing you to pick up a bit extra profit when the exposure rolls.

Soybeans Curve

A commodities index that limited its exposure-rolling system to the next-month contracts would lose money at roll time, while one that optimized its rolling system to minimize the effects of contango, or, where applicable, maximize backwardation, would profit. Which brings me to my point …

Why is anybody still investing in front-month commodities ETFs? I ask, because they are, and in a big way.

Two of the most popular commodities exchange-traded products offer front-month exposure. They are the iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca: DJP) and the iShares S&P GSCI Commodity ETF (NYSEArca: GSG), and they have $2.46 billion and $1.44 billion in assets, respectively.

Of course, the DJ-UBS and GSCI indexes are long-standing, well-established funds, so I understand why investors are attached to them.

They each offer unique portfolios—DJ-UBS uses a proprietary rules-based methodology to select and weight its commodities, while the GSCI chooses its commodities based on the liquidity of their futures contracts and weights them based on the production of each commodity.

But what if you could keep the commodities selected by your chosen index, in the weights specified by the index provider, while also optimizing the selection of futures contracts to maximize roll yield?

 

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