Shopping Across ETF Legal Structures

May 21, 2018

Commodity pools invest directly in commodity futures. These ETFs need portfolio managers, and not just for the futures positions. Commodity pool operators are tasked with investing the cash balance, often called collateral. Dollar-wise, collateral makes up most of the portfolio weight, because futures positions have zero initial cost, and their prices are reset to zero upon daily settlement. While managers need to keep some collateral in a margin account to meet daily settlement requirements, most of it can be deployed into margin-eligible securities such as T-bills or U.S. government securities in money market funds. In these days of rising interest rates, the collateral yield can be significant.

Because futures have short lives, futures-based portfolios require frequent rebalancing. This means commodity pool operators must intervene often, incurring brokerage charges, and sometimes accruing additional tracking error as they position portfolios ahead of index rolls.

Commodity pool prospectus documents often state that funds track futures price-only indexes (called excess return), but their NAVs include the collateral and its income. Collateralized commodity pool NAVs are effectively total-return NAVs, even if the pools make no cash distributions. For this reason, issuers like BlackRockInvescoUnited States Commodity Funds, and WisdomTree benchmark their commodity pools to total-return index variants.

Actively managed open-ended funds are the new kids on the commodity ETF block. Billed as a no-K-1 alternative to commodity pools, these ’40 Act funds achieve commodity exposure via offshore subsidiaries. Because there is a limit of 25% to capital allocated to the subsidiary, these funds qualify as diversified per registered investment company (RIC) specifications. The subsidiary can gear the futures exposure to match the overall asset level without issue, as futures are priced at $0.00 daily, subject to margin settlement requirements.

Clearly, these activities require significant portfolio management. Like commodity pool ETFs, actively managed open-ended funds in the commodity space require frequent rebalancing, which brings with it brokerage charges, and invites the possibility of incurring market slippage in trading executions. Market slippage is the cause of tracking error. Yet because they are actively managed funds, these ETFs do not technically track indexes, as the SEC requires these funds to file for actively managed exemptive relief. However, many state that their investment objective is closely linked to delivering the return of a specific index.

Like many open-ended funds, actively managed commodity ETFs distribute income to shareholders. Total-return NAVs must be calculated, and will accumulate value faster than regular-priced NAVs.

Cost Analysis By Legal Structure

Measuring the operating efficiency of each structure by calculating annual tracking difference is a worthwhile exercise, because there are clear bargains to be had.

Let’s compare the tracking difference for funds that track (or allude to tracking) identical indexes. The table below shows the one-year median tracking difference for ETNs, commodity pools, and active open-ended ETFs that track four different commodity indexes, contrasted with the expense ratio. Note that all NAVs and index variants are total return.

 

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