Better Commodities ETFs

June 23, 2011

A recent report says registered investment advisors won’t recommend new commodity ETFs to their clients. What a shame.

That’s because, as Ben pointed out in his blog last week, new commodities ETFs are addressing the very issues that made first-generation products so unappealing. Most recently, UBS tackled the long-standing problem related to “contango” in futures markets by rolling out two ETNs designed for investors to profit from it. That was a first, turning on its head what to think about when you think about contango.

Contango is a condition in futures markets when prices of more distant contracts cost more than near-month contracts. Early-generation ETFs that rolled exposure from a front-month contract to the next and pricier one, got creamed as those rolling costs ate into returns.

In that context, it’s no surprise that a survey we reported on last week concluded that advisors plan to steer their clients away from commodities funds. Eighty percent of RIAs now see the market as “oversaturated,” and don’t want to see any new innovation in the commodities ETF space.

A Little History

But, let’s step back for a second and look at what made these products so unpopular in the first place. As I said, investors who howled the loudest about commodities ETFs were those who got into the single-contract funds like the United States Oil Fund (NYSEArca: USO) that were exposed to the steepest part of the futures curve, meaning the worst contango.

As Ben pointed out, spot prices for light sweet crude have risen about 40 percent in the past five years, compared with a nearly 40 percent loss for USO. It’s true you could have made good money along the way in USO, but that assumes perfect entry and exit points, which is the hardest thing to do in investing.

Newer, broad-based funds like the United States Commodities Index Fund (NYSEArca: USCI), which launched in 2010, address the contango issue in two ways—first by spreading exposure out over different types of commodities that may or not be in contango, and second, by quantitatively selecting those contracts with the least amount of contango.

The fund can also goose returns by choosing contracts with the greatest amount of “backwardation”—the opposite of contango, when futures contracts have lower prices than current spot rates.

Also, for investors looking to stay concentrated in oil, ETFs like the PowerShares DB Oil Fund (NYSEArca: DBO) provide single-commodity exposure that is coupled with a quantitative methodology that minimizes contango or maximizes backwardation.

 

USO vs. DBO Spot 2-Year_Performance

DBO’s quantitative contract picking has earned investors more than 13% over USO over the last 24 months, but it still lags spot prices of West Texas Intermediate crude oil.

 

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