In futures-based commodities investing, picking the right ETP is harder than it looks.
A lot of exchange-traded products try to beat the market, but it’s only in commodities that the more active products are often more popular than their plain-vanilla counterparts.
The most popular basket commodities fund, the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), has over $7 billion in assets under management—more than three times the assets of the iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca: DJP) and nearly six times the assets of the iShares S&P GSCI Commodity-Indexed Trust (NYSEArca: GSG).
DBC’s differentiating factor is mainly that it dynamically picks the futures contracts it holds in an attempt to mitigate contango, which occurs when futures contracts are priced higher than spot with each successive month on the futures curve. This erodes returns, because maintaining exposure means paying more for a new contract than the price fetched for the contract that’s about to expire.
In contrast, plain-vanilla products like DJP and GSG simply hold the nearest-to-expire contract on each of their commodities. Every month, as those contracts near expiration, fund managers sell them and buy the new nearest-to-expire contracts.
The idea behind funds like DBC is that they can outperform even an index holding the exact same commodities by being smarter about choosing the right futures contract that will deliver the least contango possible.
Like all funds that have an element of active management, however, they come with active risk; in this case, the risk that the fund manager will pick the wrong contract.
The chart below shows DBC’s performance in 2012 against the performance of a front-month “index” I constructed based on single-commodity front-month futures indexes weighted with DBC’s current weights.
Over that year, the front-month version of DBC that I constructed outperformed DBC by about 4 percentage points.
The “index” that I constructed isn’t a perfect proxy for the front-month version of DBC—a perfect index would take into account the weights of each commodity every day, rather than apply static weights based on a single day. But it should be approximately correct.
DBC is the most popular of the commodities ETPs that dynamically pick futures contracts, but it isn’t the only one.
The United States Commodity Index Fund (NYSEArca: USCI) is the next most popular, with $520 million in assets, followed by the GS Connect S&P GSCI Enhanced Commodity Total Return Strategy ETN (NYSEArca: GSC), with $260 million.
Other, newer options include the Stream S&P Dynamic Roll Global Commodities ETF (NYSEArca: BNPC) and the RBS Rogers Enhanced Commodity ETN (NYSEArca: RGRC).
These funds have done slightly better than DBC against front-month versions of their indexes, but USCI is the only one to actually beat the front-month version of its index—or at least, earn back most of its expense ratio.
I used the same methodology as described above to construct a front-month “index” based on USCI’s holdings, but using USCI’s commodity weights at the beginning of each month. USCI, to pick more promising commodities, can and often does change its holdings every month.
USCI only lagged the front-month version of its index by 25 basis points in 2012, earning back most of its 95-basis-point expense ratio.
The ETFs that track dynamic versions of the GSCI also don’t differ that much from the GSCI—GSC underperformed the GSCI by about 1.6 percentage points and the iPath Pure Beta S&P GSCI-Weighted ETN (NYSEArca: SBV) underperformed it by about 1.7 percentage points. They’re not earning their expense ratios, but they’re also not losing much more money than their expense ratios would suggest.
It should be noted that the analysis I’ve done here focuses on just one year, and the funds highlighted above may do a better job of managing roll yield in other years.
It’s clear, however, that it would be foolhardy to assume that just because a fund is actively managing its contract selection means that it is adding value by doing so.
Roll yield is also just a part of commodity returns, and can sometimes be a relatively small component of overall returns. After all, DBC was the top-performing fund of the bunch in 2012.
Commodity selection still matters a lot. Just be sure that you’re going into your fund of choice with open eyes.
At the time this article was written, the author held a position in DBC. Contact Carolyn Hill at [email protected].
