This Changes Everything

February 03, 2006

The Deutsche Bank Commodity Index ETF begins trading on the American Stock Exchange; it’s Katie-Bar-The-Door for the ETF industry.

As one person involved in the launch said to me this morning: This changes everything.

The Deutsche Bank Commodity Index Tracking Fund was scheulde to begin trading on the American Stock Exchange (AMEX) on Friday, February 3, under the ticker symbol "DBC."   The fund tracks a (somewhat) diversified commodities index created by Deutsche Bank, and offers equity investors the first direct equitized access to the commodities market … ever. 

The fund also breaks important new ground for the broader U.S. ETF industry, as it is the first ETF ever to make use of derivatives. If the Securities and Exchange Commission (SEC) can get comfortable with derivatives in ETFs, the possibilities are literally endless: Think hedged ETFs, leveraged ETFs, oil ETFs, local housing market ETFs, ETFs to hedge or play macroeconomic indicators or market volatility, etc.

The launch is also a triumph for the AMEX's ETF listings division, which is still stumbling from the body-blow delivered by Barclays Global Investors back in July of 2005.

The Basics: A Look At The Fund

DBC is technically a "commodities pool," using futures contracts to create direct exposure to the commodities marketplace.  Specifically, the fund will invest in a basket of futures contracts designed to track the DB Commodity Index, which consists of six commodities at the following weights:

·        Light, sweet crude oil (35%)

·        Heating oil (20%)

·        Aluminum (12.5%)

·        Corn (12.5%)

·        Wheat (12.5%)

·        Gold (10%)

 

The weightings will be reset on an annual basis. The energy contracts (crude and heating oil) will be rolled forward on a monthly basis, while the aluminum, corn, wheat and gold contracts will be held for one-year terms.

The index's simple construction distinguishes it from other commodity indexes; the six major U.S. commodities indexes hold between 17 and 35 commodities contracts.

The simplified nature of the DB index is both its blessing and its curse. On the one hand, it probably helped speed fund through SEC review.  Barclays Global Investors (BGI) also filed for the right to launch a commodity index ETF around the same time as Deutsche Bank, but it chose to base its product on the Goldman Sachs Commodity Index (GSCI), which features 24 components; there is no word yet on when SEC approval for that fund will arrive.   On the other hand, the fund's simplicity may make it more volatile than other, more diversified commodity funds. Moreover, the DB fund avoids two of the six main commodity categories entirely - softs (coffee, sugar, etc.) and livestock - a fact that could alienate commodities purists.

A commodities ETF tracking the ol-rich GSCI already trades in Europe - the EasyETF GSCI from AXA Investment Managers and BNP Paribas. (http://www.swx.com/trading/products/funds/finder_etf_detail_en.html?id=GSCID

Compared to other available commodity indexes, the GSCI aside, the DB has a relatively high weighting of energy (55 percent) and the highest weighting of both precious metals (10 percent) and grains (25 percent).

The DB index is actually quite different from the GSCI, and if BGI makes it to market with their ETF, investors will have to choose carefully - the two will deliver very different returns if the commodities market doesn't move as a coherent whole. The BGI fund will be effectively tied to Energy, with its 75 percent weighting, while DBCI will be influenced by grains and gold as well.

"The Deustche Bank Commodity Index is probably better known throughout Europe and Asia, where it's been around since February 2003" said Kevin Rich, chief executive officer of Deutsche Commodities, the group behind the ETF.  "We didn't want an index that was all energy. With 55 percent exposure, we feel that the index has a nice level of exposure to energy."

INDEX WEIGHTINGS

CRB

GSCI

SPCI

DJ-AIGCI

RICI

DBCI

Components

19

24

17

19

35

6

Energy

39%

75%

49%

33%

44%

55%

Grains

13%

8%

23%

21%

21%

25%

Industrial Metals

13%

8%

4%

18%

14%

12.5%

Livestock

7%

5%

7%

10%

3%

---

Precious Metals

7%

2%

4%

8%

7%

10%

Softs

21%

3%

14%

6%

11%

---

2006 weightings. CRB is Reuters/Jeffries CRB Index. GSCI is Goldman Sachs Commodities Index.  SPCI is S&P Commodity Index. DJ-AIGCI is Dow Jones-AIG Commodity Index.  RICI is Rogers International Commodities Index. DBCI is Deutsche Bank Commodities Index.

The fund will charge investors approximately 1.45 percent in annual expenses, after the initial offering period.  That's high for an ETF, but well below the 2+ percent charged by the average commodity mutual fund on the market today (and that's before you get to the onerous loads, which can range upwards of 5 percent).  DBC compares well with one of the most reasonably-priced funds on the market, the no-load PIMCO Commodity RealReturn Fund, which charges up to 1.49 percent (including 12-1b fees) with no load.

Moreover, investors in DBC won't actually have to pay a nickel, thanks to interest on cash and Treasury deposits held by the fund.  Like most commodities funds, DBC will use leverage to purchase its futures contracts - putting up only a portion of the value of those contracts as collateral. The remaining cash will be invested in U.S. Treasuries and cash, and the interest income will be included in the performance of the fund.  Based on current rates, the fund expects to earn 3.91 percent each year, enough to pay the expense ratio and kick an extra 2.46 percent return into the fund.

Beyond mutual funds, the only other equity-like option open to investors right now in the commodities arena are the TRAKRs options contracts from the Chicago Mercantile Exchange (CME). The CME offers TRAKRs tied to both the DJ-AIG Commodity Index and the Rogers International Commodities Index. TRAKRs are futures contracts that trade like stocks, and are not leveraged; they can, however, be hard to purchase through some brokerages, and they must be rolled forward periodically to maintain long-term exposure.

Is Now A Good Time For Commodities?

The question on some people's minds is whether, despite the fast approval, this fund has come too late to the party. Gold is already trading at a 23-year high, and oil is at $60+ per barrel; where else could they go?

Up, say some.  According to legendary investor Jim Rogers, founder of the Rogers International Commodities Index, we're in the midst of a "super-bull cycle" - a 15-20 year cycle where commodities will outperform the market. Rogers says that it's a historical pattern, as the commodities industry see-saws from huge underinvestment (the last lead smelter, for instance, was built in the 1970s) to huge over-investment (think oil drilling right now).

And that's before we get to the burgeoning demand from India, China and others.

Breaking New Ground For ETFs

As important as this fund is for investors, it's just as important for the broader ETF industry.  As mentioned, DBC marks the first time the SEC has approved an ETF that relies on derivatives contracts (in this case, futures).  And once you approve derivatives, it's "Katie Bar The Door" as far as what can be equitized on the stock market:  Leveraged ETFs, hedged products, interest rate products, and a thousand other possibilities open up.

In fact, many of these funds are already in registration at the SEC, and the quick approval of the DBC fund (six months under review) bodes well for their approval soon. High on investor wish lists are the two oil ETFs (from Ameristock and Macro Securities) and the leveraged stock market index ETFs from ProFunds, all three of which are in registration; the leveraged ETFs have been at the SEC for years.

Some marveled at teh quick review of the DBC fund - just six months - but Rich said that it was a fairly straightforward process.

"When we filed with the SEC, our filings were very complete," said Rich.  "The product tracks an index of highly liquid and regulated commodities futures.  [So it was] not really that out of the ordinary, and most regulators got it right away.  It was really just a question of putting together the pieces, with the SEC regulating equities and IPOs and the CFTC (Commodities Futurees Trading Commission) regulated futures."

Big News For The Amex

The listing is certainly great news for the Amex's ETF department, which is still reeling from BGI's decision in July 2005 to transfer the listing of its ETFs from the AMEX to the NYSE.  The AMEX had prided itself on its ability to innovate in the ETF industry, however, and they deserve full credit for helping speed this product through to approval.  The fact that they beat the NYSE and BGI to list the first commodities ETF can't hurt their efforts to attract new innovative products.  As everyone knows, first mover advantage is tremendously important in the ETF industry, and the ability to deliver first-mover advantage would be a huge selling point for any exchange.

"The AMEX has always been the leader financial innovation," said Rich. "They've got a  great set of people with a great track record. If you look at new prodcuts that come up, the AMEX has been the leader. Because this was a new concept, we wanted to work with capable and experience people, and that's what we found in the Amex."

In one interesting note, PowerShares managed to get its foot into the door with this fund as well. Although this is not a PowerShares fund, the rapidly-expanding (and recently acquired) ETF provider will serve as the sales and marketing agent for the fund.  That can only help PowerShares in its distribution efforts, as chances are, the phones are ringing off the hook on this one right now…

Further reading:

IndexUniverse.com's coverage of the original SEC approval of the DBC fund is available here.

The marketing brochure for the fund is available here.

The prospectus is available here.

The Web site for the fund is here.

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