A much-anticipated ETF hits the market-along with some questions.

    Oil ... gold ... natural gas ... it's all you hear about these days. People used to talk about Internet and biotechnology stocks; now they talk about aluminum and cement. With prices rising, investors sank $6 billion into commodity mutual funds last year, and the money's still flowing today.
Perhaps that's why I've gotten so many questions recently about the new Deutsche Bank commodities ETF, or DBC, which began trading on the NYSE on February 3. The fund is the first diversified commodities ETF in the United States, and investors celebrated the launch like it was a long-awaited liberation. Some folks are even calling it the "Holy Grail."
    It's easy to see why. We all know we should invest in commodities. With their negative correlation to stocks and positive correlation to inflation, commodities are the ultimate hedge. Plus, China and India are gobbling up commodities with their rapid growth, and prices are surging.
    Historically, however, investing in commodities has been difficult. You didn't want to buy the physical commodities. Where would you put them? Oil leaks, corn rots, and cattle, well, cattle are alive!  You could buy futures, but futures come with leverage risks and special regulations. Some advisors bought shares in commodities-producing companies, but research shows that these investments are more closely correlated with the stock market than with actual commodity prices.
    The best solution for most investors has been to buy one of the many commodities "pools," which are basically mutual funds that own and trade a diverse portfolio of commodities futures. But in an industry famous for high costs, these mutual funds are the sine qua non. Many funds come with heavy loads, and even the best funds-like the PIMCO Real Return fund-charge upwards of 1.25% per year. Others charge as much as 5% per year.
    But an ETF ... an ETF should solve all that. ETFs are famous for offering low-cost, diversified exposure to different asset classes. A real commodities ETF would open up one of the world's most important asset classes to investors of all sizes, right?
    As always, it pays to examine the details.
    Let's start with costs. ETFs are known for being low-cost, with most charging less than 50 basis points in expenses. And DBC is certainly cheaper than many commodity funds. But even after a post-launch expense ratio reduction, DBC still charges a hefty 1.3%, more than twice the average for an ETF. Like most commodities funds, this cost is offset by interest income generated by the fund-but, ultimately, it still comes out of your pocket. Put simply, commodity transactions are more expensive than those of most securities.
    Then there's the issue of diversity. ETFs are famous for offering broad, indexed and diversified exposure to different asset classes. How does DBC fare? Well, the fund does track an index-the Deutsche Bank Commodities Index-but that index is very concentrated, holding just six futures contracts at fixed weights:
    Light, sweet crude oil (35%)
    Heating oil (20%)
    Aluminum (12.5%)
    Corn (12.5%)
    Wheat (12.5%)
    Gold (10%)
    By contrast, the five other major commodities indexes in the U.S. hold between 17 and 35 different commodities each. DBC doesn't have any exposure at all to Livestock or "Softs" (tropical goods like sugar), two of the six major classes of commodities; a competing index features everything from barley to adzuki beans. (See Figure 1.)

    DBC's streamlined portfolio has some advantages. DBC's six commodities are among the most liquid in the world, which lowers transactions costs and improves the spreads on trading. And these commodities do capture the gist of the market. But the lack of diversification makes DBC's index substantially more volatile than competing indexes. Over the past ten years, the standard deviation of the DBC index has topped 19%, making it the second-most volatile commodities index after the GSCI, which has a huge (75%) concentration in energy. The lack of diversification has encouraged some advisors to hold off investing in DBC for the moment.
    "I have not started to use it [DBC] for clients just yet," says Roger Nusbaum, portfolio manager for Your Source Financial in Phoenix. "I am under the impression that there will be other single-commodity ETFs and other currency ETFs coming soon. I think a blend of those, when they list, might be a better choice."
    Nusbaum is right about the funds in the hopper: In addition to the two gold ETFs on the market today, there are two oil ETFs and a silver bullion ETF in registration with the SEC, and there's always chatter about copper, natural gas and other products. There's also a second diversified-commodities ETF in registration, from Barclays Global Investors, which will track the energy-heavy GSCI.
    Before you put clients into any of these funds, however, it's important to understand how futures-based commodity funds generate returns. Most people assume that these funds will track the price of the underlying commodities: i.e., if oil and gold go up, the fund will do well. That's true, but only to an extent. There are two other factors that influence performance, and historically, these factors have actually been the main sources of return.
    The first is what's known as the "collateralized return." In the futures market, you don't put up all of the money to establish a position. Usually, you put up just 5% to 10% of the position in cash. In DBC, as in other commodities funds, the remaining cash is invested in Treasury bonds, which pay interest. According to the prospectus for DBC, these bonds would yield 4.93% per year based on current interest rates.
    The third, and historically the largest, source of return is the "roll yield." For some futures, the "spot price" is usually higher than the futures price. For instance, oil might cost $60/barrel today, but the April 2007 oil contract sells for only $50/barrel. It's called "backwardation," and there's a debate about why it happens. You can think of it as the insurance premium that a risk-averse seller pays to lock in a certain price in the future.
    For people holding futures contracts, this is great news. You buy a contract today, and assuming the price stays equal, the value of that contract rolls up towards the true value of the commodity as time goes by. When you "roll over" your futures position-swapping an expiring contract for one dated out into the future-you pay less for the new contract than the old one is worth. This difference is the roll yield.   
    Deutsche Bank actually considered this when they designed their index. For most of the past 50 years, energy futures have had a strong positive roll yield, while most other futures contracts have not. To capture this difference, DBC rolls its two energy futures contracts every month, while it holds on to its other four contracts for a one-year period. That's a neat strategy. I'm an index guy, and that is good index design.
    Except, it doesn't always work. Sometimes-for instance, when traders expect the price of a commodity to rise in the future, or when a lot of people want to buy futures contracts -the futures can actually cost more than the spot price. That's called "contango," and it's not good for futures investors. The roll yield suddenly becomes negative.
    Unfortunately, that's exactly the situation we're in right now. For the first time in years, energy futures are in serious contango. In fact, oil futures are so deeply in contango that, by some estimates, oil would have to rise to $77/barrel this year for a continuous futures position to break even. As a result, DBC, and indeed all commodities futures funds, are fighting an uphill battle.
    The DBC is an interesting development, and its designers deserve a lot of credit for getting the product out into the world. But deciding to add DBC to your portfolio is not as simple as thinking that the world needs more commodities, or that China is on the upswing. Commodities can play an important role in a portfolio, and DBC can be a good vehicle to add them. But with oil deeply in contango, and expenses still on the high side, a shade of extra care is needed.

Matt Hougan is editor of IndexUniverse.com and assistant editor of Journal of Indexes.