UBS ETNs Seek To Smooth Out Commodity Ride

April 09, 2008

Another family of commodity products? Commodity ETNs that span the spectrum of exposure.

  • An all-encompassing approach
  • A direct showdown with competing strategies
  • Which will produce better returns?

Another family of commodity products?

That thought must be going through the minds of many investors, following the April 2 launch of the E-TRACS UBS Bloomberg Commodity Index ETNs on the NYSE Arca. But these new notes include some features that could draw interest from a wide array of investors, regardless of where commodities markets are headed.

The launch included seven notes that track various UBS Bloomberg Commodity indexes including general commodities, agricultural, industrial metals, energy, food, livestock, gold and silver. Each is designed to track its UBS Bloomberg CMCI ("Constant Maturity Commodities Index"). Their "constant maturity" feature is the key to understanding how these ETNs differ from competing products.

Because most commodities products track the price of futures contracts, and not the actual commodity itself, the return on those products does not always reflect the spot price for the underlying commodity. Sometimes, commodities futures dated out into the future are priced higher than the current month's contract, a condition known as "contango." The opposite situation is known as "backwardation," when out-month contracts are priced lower than the current month's contract price.

Historically, the impact of contango and backwardation has been the largest on the "front-month" contracts - which are the contracts tracked by the "first generation" of commodity indexes.

These funds have suffered off and on over the past two years, due to severe contango in various markets. Fund companies have rushed to launch new products that cope with this contango, moving out the futures yield curve - one month, two months, three months or more - to sidestep these problems.

No Restrictions

The UBS Bloomberg indexes take this one step further, seeking to better reflect returns from spot prices by including maturities that go out as far as the underlying futures contract do ... no restrictions.

"UBS believes that the solution to many of the recent issues faced by investors" in the exchange-traded commodities markets "lies not in creating increasingly complex vehicles, such as some of the recently emerged rule-based indices or long/short strategies, but in providing greater flexibility and choice," writes the company in its technical documentation explaining the CMCI.

"The CMCI allows investors to escape the limitations of ‘nearby only' vehicles embodied by many major commodity indices," continues UBS. "Single forward strategies offered by baskets of forwards/futures, or even ‘optimised' roll approaches offered by the more recently emerged complex vehicles, serve to that extent, the same purpose of locking investors into potentially undesirable parts of the curve and as the tenor of the investment may continuously change."

One competitor, the PowerShares-Deutsche Bank collaboration, offers several exchange-traded commodities index funds (ETFs as opposed to ETNs) using complex rules that govern the movement of the index. The indexes have the discretion to pick the contract that they think will deliver best return, minimizing the impact of contango and maximizing the impact of backwardation.

Complex Rules

Lehman Brothers also uses a complex rules set for its ETNs branded under the Opta family of funds called the Opta Lehman Brothers Commodity Index (LBCI) Pure Beta Total Return ETN.

"For each commodity in the LBCI Pure Beta," says a Lehman Brothers fact sheet for the fund, "an algorithm determines the particular futures contract in which to invest each quarter. This algorithm selects forward contracts for each commodity based on the contract month whose price most closely correlates to the average price for that commodity across all contract months in the 0- to 12-month measurement period, weighted by the total dollar amount."

As UBS points out, its benchmark "include[s] all opportunities realistically available to investors. Since a commodities index is based on futures contracts, then it should include all tradable parts of the forward curve and not be artificially restricted to the first couple of months." Or restricted to some sort of complex algorithm if the goal is to most closely reflect the underlying commodities markets, not just return the highest yield.

Another important consideration in looking at each of these exchange-traded commodity investments is looking at the investment management fees that each company charges its investors.

Deutsche PowerShares charges a relatively high 75 basis points for management of its funds, plus expects investors to incur another .08% in brokerage fees. That seems relatively high for an unmanaged investment. Lehman's Opta charges a whopping 85 basis points but says nothing about brokerage fees. UBS' fees are more modest, coming in at 65 basis points, which seem more in line with an unmanaged fund.

At the end of the day however, all investors should be aware that regardless of costs, there are inherent difficulties in trying to create the "best" commodity index. Simply put, most investors can't buy and store physical commodities in markets like oil, grains, etc., in the same way you can with gold or silver bullion. And so, you can't truly buy the spot returns ... but these ETNs could give you a chance to get a little closer to the goal.

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