GSG Tracking: What Really Happened?

July 27, 2011

The inside story of why a popular commodities ETF lagged its index in a big way.


[This article originally appeared in the July issue of our Exchange-Traded Funds Report.]


When it comes to commodity indexes, the S&P GSCI is far and away the leader. More than $100 billion in assets is tied to this index, including nearly $2 billion split between two popular exchange-traded products: the $1.7 billion iShares S&P GSCI Commodity-Indexed Trust (NYSE Arca: GSG) and its smaller cousin, the $121 million iPath S&P GSCI Total Return Index ETN (NYSE Arca: GSP).

The two products aim to do the exact same thing: provide investors with exposure to the S&P GSCI Total Return Index. Compare recent returns, however, and you get two very different pictures: As of June 6, GSG had returned 3.95 percent year-to-date, while GSP had returned 6.03 percent. Considering that the actual S&P GSCI benchmark is up 6.13 percent, GSG has underperformed expectations.

Do investors have this wrong? Is the $1.7 billion in GSG tracking an inferior product? Should they swap out for GSP immediately?

Not necessarily—the story is more complex than it looks.

Two Approaches To Tracking The Index
While GSP and GSG aim to track the same index, they do so in different ways that promise two different kinds of results.

As an ETN, GSP eliminates tracking error. ETNs are structured as debt notes, whereby the underwriting bank—in this case, Barclays Capital—guarantees to deliver the exact return of the benchmark index. Barring unusual events, ETNs will track nearly perfectly to their indexes, and GSP has delivered on this promise.

There is no such thing as a free lunch, of course, and the perfect tracking of GSP comes with an important caveat: counterparty risk. As a debt note, GSP is fully susceptible to a default by Barclays. In the event that Barclays defaults, GSP investors will face substantial losses. The worst-case scenario is something akin to the failure of Lehman Brothers in 2008, which essentially wiped out investors in three ETNs issued by that company.

GSG doesn’t share that counterparty risk; it is structured as a trust. That means it actually purchases and holds assets designed to provide exposure to the S&P GSCI. Shareholders in the fund have a pro rata stake in those underlying holdings, and no default by iShares’ parent company BlackRock can take that away.

GSG is a bit unusual in that, unlike most commodity ETFs, it purchases a specific type of futures contract traded on the Chicago Mercantile Exchange called commodity excess return futures, or CERFs. Unlike traditional futures contracts, CERFs are designed to provide long-term exposure to a given asset class. The CME has listed two CERF contracts since 2006, which have had durations of five years and three and a half years, respectively. That contrasts with typical futures contracts that expire monthly or quarterly.

There are a number of potential reasons why iShares chose CERFs rather than traditional futures contracts to underlie the GSG product. The first is transaction costs: By having to roll over its contracts less frequently, GSG should reap savings—at least in theory. That’s offset by the fact that the CERFs GSG holds are relatively illiquid. iShares dominates the market for CERFs, holding more than 88 percent of the current open interest.

Figure 1

The Source Of Recent Tracking Error
One obvious question is whether the use of CERFs—as opposed to traditional (and more liquid) futures contracts—has increased the likelihood of negative tracking error for GSG.

A look at the annual returns for GSG suggests otherwise. In 2009, for instance, GSG actually outperformed its benchmark by 1.64 percent. That move came after two years of underperformance, which may indicate that the fund’s tracking error is mean-reverting.

The long-term track record backs that up. Since inception in 2006, GSG has returned -27.54 percent, just 3.97 percent below the benchmark return. That is very close to the 3.70 underperformance that would be expected based solely on the 0.75 percent annual expense ratio compounded over five years.

While it’s impossible to say exactly what caused GSG’s recent underperformance, there are two leading theories—both of which, curiously, actually augur well for the fund.

The first is that 2011 was the first-ever roll by GSG. With the starting round of contracts expiring, iShares had to roll the entire portfolio into new contracts. This could theoretically have led to slippage.

There’s no exact way to test this, however, and the previous variability of tracking performance says that this is unlikely to be the true driver of the returns difference. If it were, investors would not have to worry about it again until the spring of 2014, when the next wave of CERFs expire.

The second and more likely explanation is futures mispricing, whereby GSG’s underlying holdings—the CME CERFs—trade away from their intrinsic value. Futures contracts are designed to converge with spot returns by expiration; prior to expiration, they may temporarily trade away from “fair value.” Under this scenario, the vacillating tracking performance would be driven by movements above and below fair value for the underlying contracts.

This would cause the tracking error to be roughly mean-reverting—after all, the CERFs must revert to fair value by their expiration in March 2014. If they underperformed this year, then one might expect them to reverse course in ensuing years. That roughly aligns with the variable annual tracking performance we’ve seen since GSG’s launch in 2006, and would suggest that periods of underperformance will eventually be matched by periods of outperformance.

In short, we can expect to see the different tracking experiences continue. While this year’s 2.18 percent underperformance is concerning, history suggests that much of that may be reversed in the future. This is especially true in light of GSG’s extremely solid tracking performance since the trust’s inception.

Rival GSP—the ETN—has had more consistent performance, staying tighter with the underlying index. Over the long haul, it has generated slightly superior performance for investors, with a 3 percent underperformance over the same period compared to GSG’s 3.97 percent.

For many investors, the tighter tracking performance of GSP must be weighed against its greater credit risk and inferior liquidity, with the latter point being perhaps the most important consideration.

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