FTGC: Next-Generation Commodity ETF

What's the real story behind the red-hot active commodity ETF from First Trust?

For a number of reasons, I’ve been following the First Trust Global Tactical Commodity Strategy Fund (FTGC | C) since its launch in late October 2013.

For starters, FTGC is a pioneer in the commodities ETF space in two ways: its actively managed investment strategy; and the open-ended structure it has as a security registered under the Investment Company Act of 1940 Act, which gives it unique tax implications.

Of course, FTGC crushing its peers in performance jumped out at me as well. FTGC has managed to return more than 12 percent since its launch on Oct. 23, 2013. During that same period, the S&P GSCI Total Return Index—our benchmark for the segment—returned 4.6 percent.

Chart courtesy of StockCharts.com

But to understand the secret behind FTGC’s stellar performance in its short life span thus far, we need to understand what separates it from the rest of the pack.

Active Management

FTGC is the first and only actively managed commodities ETF. This active management has really been the secret behind FTGC’s performance, according to Ryan Issakainen, an ETF strategist at First Trust.

“Traditional commodity indexes select and weight based on production and liquidity, while we constructed a portfolio based on volatility and correlations,” he told me recently.

Basically FTGC favors commodities exhibiting less volatility and lower correlations relative to other commodities. This approach creates quite a different portfolio from many popular indexes that tend to favor energy.

I looked at FTGC’s portfolio shortly after its launch, and you can see why it’s performed so well.

Sources: ETF.com and First Trust's website

FTGC was heavily positioned in agriculture right before the sector surged starting late January 2014. Notice that the fund has trimmed its position in the sector since.

Active management also allows FTGC flexibility in selecting contracts on the futures curve. Returns from commodities ETFs are greatly affected by positive or negative roll yields, depending on whether the targeted commodity is in contango or backwardation.

Issakainen believes that having flexibility to choose contracts on the futures curve is beneficial because it’s difficult quantifying this strategy for geopolitical events or unexpected seasonality issues.

’40 Act Structure And Taxation

As I pointed out above, FTGC is the first commodity ETF structured as a 1940 Act, open-ended fund.

The fund trades and holds futures contracts through a subsidiary based in the Cayman Islands. The fund’s weighting in this subsidiary “holding” is limited to 25 percent, allowing it to be taxed like a regulated investment company.

The beauty behind this structure is that shareholders get futures exposure to commodities, but don’t have to deal with K-1 forms that irk many retail investors. Tax reporting is done on a 1099, just like any other equity or fixed-income ETF.

That said, tax implications can be mixed, depending on your preferences.

Since FTGC is a ’40 Act fund, gains made by those futures contracts are likely to be distributed to its shareholders before the end of the year. Furthermore, those gains are likely to be taxed as ordinary income.

This differs from ETFs structured as commodities pools, which get marked to market at year end, but gains are taxed like futures, which is to say that 60 percent are taxed at long-term capital gains rates and 40 percent at short-term capital gains rates. Together, the combination equates to a maximum blended rate of 27.84 percent.

So there’s the trade-off, and investors will need to weigh those differences based on their preferences.

Worth mentioning is that FTGC wasn’t the first ETF to use this structure. But it is the first pure commodity ETF to do so, though there have been “managed futures” ETFs trading prior to FTGC.

The Future Of FTGC

When I say that FTGC is a “next generation” commodity ETF, I’m mainly referring to its structure. Before FTGC, investors looking for commodity futures exposure either had to buy shares in a commodities pool (with K-1s) or go with an ETN, which, of course, carries counterparty risk.

Now, it looks like others are following suit. Global X recently filed for an actively managed commodity ETF structured similarly to FTGC. I’m curious to see how many more will be launching in the coming years.

FTGC has had inflows of $141 million year-to-date, putting its assets under management at $142 million. Liquidity has picked up too: It now trades more than $1.7 million worth of shares on most days, at 15 basis point spreads.

Clearly, seven months of outperformance isn’t enough history to make any definitive conclusions. FTGC could conceivably underperform its indexed peers in the coming seven months.

That said, I believe in giving credit where it’s due: So thus far, hats off to the managers of FTGC.

It’ll be interesting to see how their volatility and correlation-based strategy does going forward in different market environments, and what any tax implications would look like if they’re able to maintain the stellar performance for the remainder of 2014.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.