A Contango-Killer ETF Primer

June 17, 2011

Contango-killing commodities ETFs are all the rage these days, and it’s worth getting under the hood of some of them to take measure of their differences.

Contango occurs in futures markets when contract prices ratchet upward over time, meaning the front month is the cheapest, and fund managers have to pay up to maintain exposure each time they prepare for a given contract to expire.

Contango is pretty much of a nightmare and, notwithstanding a hard-to-believe recent survey saying a large majority of advisors aren’t interested in any more commodities funds, commodities investors would be wise to get their heads around it.

Consider for a moment that while spot crude prices have risen almost 40 percent in the past five years, the United States Oil Fund (NYSEArca: USO) has fallen by more than 40 percent. It’s no wonder USO’s sort of become the poster child for the pernicious effects of contango.

While USO, amazingly, remains a $1.2 billion fund, the ETF industry has fortunately moved well beyond front-month exposure strategies such as USO uses. Trying to limit contango, or profit from its opposite, backwardation—when front-month futures contracts are the priciest—is a big focus these days.

I’ve heard John Hyland, chief investment officer of United States Commodity Funds, the company behind USO, refer to these ETFs as third-generation commodity funds.

First-generation funds, like USO, own only front-month contracts. The second generation consists of multiple contracts of the same commodity, like the United State 12 Month Oil Fund (NYSEArca: USL), which maintains rolling exposure to 12 months of futures contracts.

The third-generation funds, with multiple commodities and various contango-killing exposure strategies, haven’t been around for long, but it may be worth taking a look at performance to see how well they do.

The largest fund in the space for diversified third-generation commodity funds is the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), with $6.08 billion in assets under management. DBC has significantly outperformed its competitors, with a return over the last six months of 11.84 percent.

AUM($m)

1 Month

3 Month

6 Month

DBC

6084.67

1.52%

3.47%

11.84%

USCI

484.92

0.48%

-0.71%

7.04%

UCI

142.72

1.91%

2.21%

7.32%

DBC claims to invest in the 14 most important commodities based on world production and supply. The fund rolls into contracts with the implied roll yield that gives the lowest contango or the highest backwardation—excluding contracts more than 13 months away from expiration.

The UBC E-TRACS CMCI Total Return ETN (NYSEArca: UCI) is similar in that it tries to limit contango by doing more than investing in front-month contracts. The fund tracks 26 commodities and invests in five constant maturities from three months up to three years. The fund takes a long-term diversified approach to limiting contango.

The newest arrival in the space is the United States Commodity Index Fund (NYSEArca: USCI), which goes the extra step of trying to limit contango by changing the commodities it invests in, while also choosing the best contract.

 

 

USCI invests in 14 equal-weighted commodities. The fund first picks the seven commodities that exhibit the highest backwardation or the lowest contango. Then USCI picks seven more commodities that have exhibited the highest price momentum, while making sure to have one commodity within all the major segments of the commodities world.

DBC

USCI

UCI

Agriculture

20.81

42.72

29.00%

Energy

61.82

29.06

34.00%

Industrial Metals

7.27

6.57

27.00%

Livestock

0

7.63

4.00%

Precious Metals

10.11

6.82

6.00%

DBC is heavily concentrated in the energy segment (over 61 percent). Is the outperformance due to energy outperformance or is their strategy better? We can actually use DBC’s current weights versus targeted weights as a proxy.

The fund rebalances the portfolio annually each November. Although the rebalancing took place seven months ago, the general direction of the changes in its holdings shows the segments that have outperformed. Specifically, it’s energy that has had higher returns than all the other segments.

 

Base Weights

Actual

Agriculture

22.52

20.81

Energy

55.02

61.82

Industrial Metals

12.51

7.27

Livestock

0

0

Precious Metals

10

10.11

 

The GSCI Energy Total Return Index has gained 9.6 percent in the past six months compared to the S&P GSCI Agriculture & Livestock Index, which earned 2.35 percent. How much of DBC’s returns are attributed to energy is difficult to know, but the fund has clearly benefited from being overweight that sector.

USCI has only been around since August, which isn’t nearly enough time to reach a verdict on its relative performance. The fund is not heavily concentrated like DBC, and will likely outperform DBC if oil underperforms other commodities.

It seems a fair bet we’ll see more funds coming to market that try to minimize the deleterious effects of contango, never mind that survey saying advisors aren’t interested. If anything, studies like that—suggesting the status quo is just fine—betray an unsettling and costly lack of knowledge.

 

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