Investors love commodities based exchange-traded funds. But they hate contango, that nasty little quirk that occurs when distant commodities futures prices are greater than near-term prices. Investors lose money when ETFs roll expiring contracts into more expensive future contracts.
But help might be on the way to help side step contango, said panelists at the fourth annual Inside Commodities conference held last Thursday at the New York Stock Exchange.
Matt Hougan, president of ETF analytics at Index Universe, the organizer of the conference, noted that contango has resulted in some exchange-traded products that have racked up net losses over the past decade while commodity prices have actually gone up, leaving some investors wondering how that happened.
So-called third generation of commodity funds seek to mitigate this issue by blurring the line between index and active fund management with portfolio configuration rules that determine commodity exposure based on the desirability of futures contracts rather than the fundamentals of commodities themselves.
The initial generation of funds, which date back to 2005, were balanced selections of commodities based on their liquidity and respective economic importance. The second generation of funds, whose composition was still driven by an ostensibly desirable mix of commodities, started selecting contract maturities based on positive roll yields, which occurs when distant commodities futures prices are less than near-term prices. This condition, know as backwardation, is the opposite of contango.
"Except for high-priced commodities like gold and platinum, it's far too expensive for funds to hold the physical commodities, leaving futures contracts the only way to provide investor exposure to this asset class," said John Hyland, chief investment officer of the California-based US Commodity Funds. "So the problem for longer-term investors has been that they couldn't escape the impact spreads between contract and spot prices have had on total returns."
Hyland's US Commodity Index Fund, which began in late 2010 and now has with more than $400 million in assets, puts itself into the third-generation fund category due its methodology that systematically selects 14 commodity futures contracts (from a list of 27 possible commodity futures contracts) based on futures contract prices that are lower than their respective spot rates. In effect, the fund is trying to capture backwardation markets. Backwardation conditions suggest tight supplies and indicate upward moving price trends because commodities with low inventories tend to outperform those with high inventories.
By devising an index formula that actively looks for contracts that maximizes this positive spread, or positive roll yield, the fund theoretically should be more profitable than first generation commodity indices.
Structuring a commodities portfolio based on yield spreads also addresses a fundamental issue that Martin Kremenstein, CIO of Deutsche Bank's Commodity Services, raised. Namely, how to determine what is a legitimate basket of commodities and what is the market beta. Commodities don't have market caps like stocks, so he thinks it's probably a mistake to think such portfolios should be structured like an equity index.
New Methods No Panacea