The commodities market has investors singing the blues, but a
new note leads some to follow the beat of a different drummer.
Almost a year ago, the world's first broad-based commodities exchange-traded fund was being heralded as a "Holy Grail" for the ETF industry: the first product to offer investors low-cost, diversified access to the "famous negative correlation" of commodity futures.
Since its launch in February 2006, PowerShares DB Commodity Index
Tracking Fund, or DBC, has racked up about $700 million in assets and
has emerged as a powerful tool for a number of financial advisors.
"That they (the commodities ETFs) exist at all is generally a
positive," says Roger Nusbaum of Your Source Financial, a wealth and
portfolio management firm in Prescott, Arizona. "Regardless of returns,
they offer diversification that used to be much more difficult to
access."
That is undoubtedly true, but advisors have been a bit slow to embrace
the funds. While $700 million is real money, it doesn't really live up
to the "Holy Grail" billing. The streetTRACKS Gold Shares ETF (AMEX:
GLD), for instance, garnered $1 billion in its first three days of
trading, and now has more than $8 billion in assets. (Nusbaum, for the
record, uses GLD in his clients' portfolios; he does not use DBC.)
The biggest reason for the lukewarm reception is the uneven performance
of the commodities sector since DBC's launch. While you can hardly open
the paper without reading about the pending oil shortage or China's
voracious demand for commodities, the truth is that commodities haven't
been a great investment over the past year.
It's wrong to extrapolate from short-term trends, but it's hard to
escape the obvious: While stocks have marched smoothly to new highs,
DBC has been ping-ponging back and forth with enough volatility to make
Dennis Connor sea-sick. In fact, from its launch on February 6 through
the end of 2006, DBC traded virtually dead flat for the year;
meanwhile, the S&P 500 rose 12.6%.
Is that a short-term hiccup or a long-term trend? A year into the
commodities ETF revolution, it's time to take stock of what's changed
in the industry, and to consider whether ETFs make sense for investors
today.
New Products, Lower Fees
One of the biggest developments in the space over the past year is that
investors now have many more choices for their broad-based commodities
investments. While DBC was the first broad-based commodities ETF, it
was quickly joined by the iShares Goldman Sachs Commodity Index Trust
(NYSE: GSG). The fund tracks the popular (but energy-heavy) Goldman
Sachs Commodity Index (GSCI), and it provides markedly different
exposure to the commodities space than DBC (more on this later).
One great thing about GSG is that it has sparked a price war within the
commodities space. DBC originally launched with an expense ratio above
1.3%; today, both DBC and GSG charge just 75 basis points. Compared to
the 2%-plus fee levied by many commodity mutual funds, 75 basis points
is a bargain.
GSG is not the only innovation, either: Barclays Bank also has entered the fray with a new debt product that functions just like an ETF, and may be a better mousetrap. Called "exchange-traded notes," or ETNs, these products trade just like ETFs and track the performance of underlying commodity indexes. But rather than actually holding the underlying futures, the new ETNs are actually structured debt products. Barclays agrees to pay you the exact return of the underlying index (with zero tracking error), minus fees of 75 basis points.
The chief advantage-and it is a big one-is that Barclays believes that
ETNs will never have to pay out capital gains distributions; investors
will only owe taxes when they sell the notes. In comparison, most other
commodities funds must pay out ALL their gains each and every year.
Noteworthy is that futures-based investments receive unusual tax
treatment by the IRS. Sixty percent of any gains are taxed as long-term
gains, regardless of the holding period; that means that they are
subject to the same 15% tax rate that applies to long-term gains on
equity positions. The remaining 40% of gains are taxed as short-term
capital gains, which are subject to the investor's ordinary income tax
rate. This unusual 60/40 split creates a maximum blended capital gains
tax rate of 23% for investors in the highest tax bracket; the tax
burden is reduced for investors with lower incomes. Still, paying out
23% taxes each and every year is brutal. If the IRS agrees with
Barclays' interpretation, ETNs may emerge as by far the most preferable
product for taxable accounts.
"The ETN appears to be possibly the most cost-effective, accessible and transparent method for nonprofessional investors to gain access to a broad-based commodities index," says David Krein, president of DTB Capital, a structured investment boutique offering specialized advisory and brokerage services. "As long as they remain liquid and Barclays remains solvent-and the tax rulings break Barclays' way-ETNs could prove to be the vehicle of choice over the long run."
The downside of the ETNs is that, in the unlikely event that Barclays
goes bankrupt, investors will be left holding the short end of the
stick. They may also not be as liquid as traditional ETFs.
Barclays currently offers two broad-based ETNs, one tied to the
aforementioned GSCI index and one tied to the Dow Jones AIG Commodity
Index (DJ-AIGCI).
Dancing The Contango
So why haven't these commodity index ETFs exploded onto the scene? The
$700 million in assets for DBC is a decent start, but given all the
press that commodities have received, that number is still slightly
disappointing.
The reason is "contango." An investment in commodity futures earns
money three ways: 1) through changes in the spot price of the
commodity; 2) through interest income earned on collateral cash (the
cash not used to buy futures on margin); and 3) through "roll yield."
Futures contracts aren't like stocks: they expire. So if you want to
stay long, you (or your fund) will have to "roll" from one contract to
the next, selling the expiring contract and buying the new one. Often,
prices in the futures market for these "out month" contracts will be
cheaper than for the expiring contract: oil may cost $62 per barrel
today and $60 per barrel for next month. When this is the case, you
effectively make money every time you roll the contract. It's called
"backwardation," and for long investors, it's a glorious thing.
The reverse condition is called "contango." When you roll contracts
that are in contango, you effectively lose money on every trade. It's a
pernicious destroyer of returns.
Research shows that this "roll yield" is the largest single contributor
to commodities returns. Unfortunately, for the past 18 months or so,
most markets (and particularly energy) have been in "contango." So
while investors have been reading about soaring commodity prices in the
news, that hasn't translated into strong returns for commodity
investors.
Figure 1 shows the dramatic impact of the roll yield on returns for the
GSCI over the past 35 years; pay particular attention to 2005 and 2006.