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Barchart.com ETF ResearchOur Pick for a Broad Commodity Index Exchange-Traded Product ETF Research written by the Barchart.com ETF Research Team Last Updated: September 1, 2010 Table of Contents
Our pick for a broad commodity index exchange-traded productCommodities in the past decade have seen a huge influx of capital both for speculative short-term trading and long-term investment. Investors at the end of 2009 had a record $277 billion invested in commodity exchange-traded products and other securities linked to commodities, which was 50 times the $5.5 billion level seen a decade earlier, according to Barclays Capital. In this article we will use the term "exchange-traded products" (ETPs) to include both exchange-traded funds (ETFs) and exchange-traded notes (ETNs) since ETNs are a large part of the commodity index ETP market. Our earlier article entitled "An introduction to exchange-traded funds" outlines the differences between an ETF and an ETN. Traders for years have speculated in the commodity futures markets. However, the futures markets are not for investors with a modest-sized investment nest egg and are not well-suited to a long-term investment strategy due to the need to roll over expiring futures contracts. The leverage on futures contracts varies widely and depends on how particular brokerage firms set margins for their customers. For example, the leverage is about 21 to 1 for CME gold futures and 15 to 1 for CBOT corn futures at one major brokerage firm. In order to calculate the leverage on a futures contract, just divide the nominal dollar value of the futures contract by the initial overnight margin for that contract. The high amount of leverage means it can be easy to lose your trading capital very quickly if you are not careful about the high-octane leverage available in futures. ETPs, on the other hand, generally have no leverage and are therefore a much less risky way to play the commodity markets. In theory, if commodity prices go up by 5%, your commodity ETP investment will also go up by about 5% (adjusted for expense fees, investment return on cash, and the roll yield). Thus, commodity ETPs can be a good way for an investor to make some conservative and long-term plays in the commodity markets. The main downside to using ETPs for commodity speculation and investing, however, is that buy/sell commissions take a bigger bite of the profits since an investor controls a much smaller position when buying an ETP share versus a futures contract. In addition, investors need to be very careful about the impact of futures roll yields in ETPs that use front-month futures (more on that later). The commodity sector exploded in popularity when commodities were declared a separate asset class by various academic studies and when the commodity market began a huge bull market back in 2002. Institutional investors started pouring money into the sector when they decided that commodities should represent a percentage of their overall portfolio, joining other asset classes such as stocks and bonds and alternative asset classes such as real estate. The commodity sector was declared a separate asset class mainly because of its low and even negative correlation with stocks, which improves the diversification of a portfolio and can thereby improve risk-adjusted returns. The correlation between the Dow-Jones UBS Commodity Index and the S&P 500 was only 0.33 based on monthly returns in the ten years through mid-2010. The Commodity Investment CaseA strong investment case can be made for a long-term bull market in commodity prices. Commodity prices over the short run go up and down and are notoriously volatile. However, there will be a net 2.2 billion more people on earth by 2050, according to projections by the United Nations. Those people are going to require a large amount of freshly-supplied commodities to provide the raw materials needed to produce food, energy, homes, and public infrastructure (see our article on Infrastructure ETFs). On one hand, if commodity producers anticipate that increase in demand and ramp up production capacity ahead of time, then commodity prices might remain stable or even fall if supply outstrips demand. On the other hand, however, the more likely outcome is that commodity producers will not ramp up production until the demand actually emerges and prices start moving higher, thus guaranteeing producers an adequate return on their investment in new production facilities. That would create a long-term demand-led rally in commodity prices, which is the most durable and sustainable type of rally, as opposed to short-term price spikes based on temporary supply disruptions. Another reason for an investor to invest in the commodity market is to hedge his or her portfolio against inflation. Academic studies have shown that the annual excess returns of commodities are positively correlated with changes in inflation by a relatively high correlation factor of 0.52 (see "The Handbook of Commodity Investing," p. 68). The data suggests that commodity prices tend to move higher along with inflation, thus boosting the value of` a portfolio in times of inflation. This contrasts with stock and bond prices, which are hurt by inflation and fall in price during times of high inflation. Having a commodity component in your portfolio should protect the value of the portfolio to some extent during times of high inflation. Commodity prices have already far outperformed the S&P 500 index over the past 10 years, as seen in Figure 1. This chart shows the CRB Continuous Commodity Index (Barchart.com symbol $CIB) overlaid with the S&P 500 index (Barchart.com symbol: $SPX) on a monthly percentage scale chart. The chart also illustrates that commodity prices tend to be mildly more volatile than stock prices. For example, the 12-month historical volatility of the Dow-Jones UBS Commodity Index in the past decade has averaged 15.8%, which is two percentage points more than 13.8% for the S&P 500 Index. Figure 1: CRB Continuous Commodity Index versus the S&P 500 Index (link to live chart) 
Commodity Investment ProductsThere are a variety of investment vehicles available for investing in the commodity sector. These products include Exchange-Traded Products (ETPs include both ETFs and ETNs), actively-managed mutual funds, managed futures funds, and hedge funds. This article is limited to commodity ETPs, which generally track a commodity price index on a passive basis. Commodity ETPs have an advantage over mutual funds, managed funds, and hedge funds by virtue of lower expense fees. Commodity index ETPs are relatively simple to operate since they passively track a commodity index and require no subjective judgment or investment analysis. All a commodity index exchange-traded fund manager needs to do is follow the index rules for commodity weightings and roll over expiring futures contracts in the fund and keep all the weights in balance. A commodity exchanged-traded note manager has even less to do since he or she doesn’t even have to manage a portfolio (an ETN is simply a note that tracks an underlying index). Actively-managed commodity funds, on the other, are much more expensive to operate because the manager is trying to beat a benchmark and that requires more talent and resources. Commodity mutual funds can have expenses up to 2 percentage points and managed futures funds and hedge funds generally charge "2 and 20," taking a 2% annual management fee and 20% of the profits. There is of course no guarantee that these higher fees are justified by higher returns.Commodity ETP Returns and ContangoMost commodity ETFs buy futures contracts to gain exposure to commodity prices, thus relieving them of having to buy and hold physical commodities. The main advantage of using futures contracts is that the fund only needs to post margins of usually less than 10% of the nominal value of the futures contracts, allowing the fund to invest the remaining 90% of its cash in T-bills and earn a risk-free return in order to boost the overall performance of the fund. By using futures, the ETF avoids the costs and risks of buying, transporting, insuring, and storing physical commodities. In addition, many commodities are perishable and it is not feasible to hold them for a long period of time. However, there is a sticky problem that stems from using futures contracts to track commodity prices. Funds can lose as much as 5-10% of return a year if the fund progressively rolls positions forward in front-month futures contracts while the futures curve is sloping upwards, a.k.a., "contango." Contango occurs when futures contracts that expire further out into the future are trading at a higher price than the near-dated futures contracts. In a contango market, an ETF fund will almost certainly underperform the spot market pricing. Therefore, is it extremely important to consider how a specific commodity ETF holds and rolls futures contracts since that can have a big impact on its performance versus the underlying spot commodity. We will discuss the commodity roll yield problem and contango in more depth in a future article. On the brighter side, the contango problem is less of an issue for the commodity index ETPs than it is for commodity-specific sector ETFs such as oil or natural gas. With commodity index ETFs, the fund is typically diversified across more than 15 commodities, each of which will have varying degrees of contango and some of which might be in backwardation (a downward sloping curve) and provide a positive return to the fund. Shifting the discussion from ETFs to ETNs, an ETN is a note that pays a return based on the performance of its underlying index. This means that commodity ETNs do not buy and roll over futures contracts in a fund, as do ETFs. However, commodity index ETNs are based on an index that is priced in terms of futures prices, and the indexes follow pre-set rules for progressively rolling forward from expiring futures contracts. This means that commodity index ETNs end up in the same boat as ETFs on roll yields and contango even though ETNs do not specifically hold futures contracts.Broad Commodity Index ETPsThere is a long list of commodity ETP products that track broad commodity indexes, as opposed to commodity-specific sub-sectors such as oil, gold, natural gas, or agriculture. The purpose of these commodity index ETPs is to provide an investor with exposure to the commodity sector as a whole rather than to specific sub-sectors. This is a list of the six largest broad commodity index ETPs along with their ticker symbols and the assets under management as of late August 2010:
Commodity ETP Weighting SchemesThe ETPs on this list vary widely in how they weight different commodity sub-sectors. The graph in Figure 2 summarizes the various weighting schemes in the top six commodity index ETPs. The weighting scheme is a critical factor to consider when choosing a commodity index ETP since an investor wants to make sure that the ETP’s weighting scheme dovetails with his or her view of how particular commodity sub-sectors may perform in coming months or years. Many investors may not realize that they may already have more exposure to the oil and gas sector than they suspect. For example, the S&P 500 index has a fairly large weight of about 10% on the various sub-sectors of the oil and gas industries. Since oil and gas stocks trade with some correlation to oil and gas prices, an investor who holds oil and gas stocks already has exposure to oil and gas prices. A quick regression analysis indicates that oil prices have explained about 27% of the price movement of the S&P 500 Integrated Oil and Gas sub-index over the past five years. The S&P 500 index, on the other hand, has only about a combined 0.5% weight on the S&P 500 Agriculture Products sub-sector (Archer-Daniels Midland) and the S&P 500 Fertilizer/Agricultural Chemical subsector (CF Industries, Monstanto). That means that an investor has virtually no agricultural commodity price exposure from holding the S&P 500 index. The S&P 500 is also very light on metals. The S&P 500 index includes only three mining companies (Newmont, Freeport-McMoRan Copper & Gold, and Titanium Metals) with an overall weight in the S&P 500 of about 0.7%. Our view is that investors in a commodity index investment should choose one of the more balanced ETPs and avoid the ETPs that have a heavy energy exposure. Figure 2: Commodity Sub-Sector Weights – Top Commodity Index ETPs
Return ComparisonFigure 3 provides the annual returns of the top six commodity index ETPs along with their respective underlying indexes. In some cases, the index history is longer than the ETP history so that the index history provides an idea of how the ETP would have performed if it had existed.
Figure 4 ranks each of the ETPs according to how well it did over the past several years. The table illustrates that no single ETP won the top ranking in even two of the last 4 years. GSG won in 2007, DBC won in 2008, UCI won in 2009, and GCC was ahead in 2010. This table also illustrates how the performance of the various commodity sub-sectors is the critical factor driving the overall return of the index and the ETP. Generally, energy prices are the single most important factor in determining winners and losers among the broad commodity index ETPs. In years where energy prices rally sharply, the ETPs with a heavier energy weight will tend to be the winners. In years where energy prices are weak compared to other commodity sectors, then the commodity index ETPs with a lighter energy weight will win. It all comes down to a case of which commodity sub-sectors do the best in a particular year and how heavily those sub-sectors are weighted in the ETP. Figure 4: Commodity Index ETP – Return Rankings
Figure 5 shows the difference between the ETP’s annual return and that of its underlying index. This table illustrates that in most years, the commodity index ETPs showed returns that are within a couple of percentage points of their underlying indexes. This indicates that the commodity index ETPs on the whole track their underlying indexes fairly well, although there are some notable exceptions for UCI in 2009 with an 8.0 percentage point difference and DBC in 2007 with a 4.8 percentage point difference. Figure 5: ETP Performance Versus Its Underlying Index
A Detailed Look at Each ETPNow that we have set the stage for how to analyze commodity index ETPs, let’s delve into each ETP in detail. The largest commodity index ETP is the PowerShares Deutsche Bank Commodity Index Tracking Fund (DBC), which has over $4 billion of assets under management. The index has a 49.5% weight on petroleum, with 12.375% each for light crude, Brent crude, heating oil, and RBOB gasoline. The index has an even larger overall 55% weight on energy after including its 5.5% weight on natural gas. The remainder of the index has a 22.5% weight on metals (8% for gold, 2% for silver, and 4.167% each for aluminum, zinc, and copper), a 16.875% weight on agricultural commodities (i.e., a 5.625% weight each for of corn, wheat, soybeans), and a 5.625% weight on softs (i.e., sugar). This ETF has adopted a methodology for trying to mitigate the negative effects of contango on returns. The second largest exchange-traded product is the iPath® Dow Jones-UBS Commodity Index Total Return ETN, which has about $2.0 billion under management. This exchange-traded note (ETN) has a fairly equal weighting scheme across commodity sub-sectors, which we like. The ETN has a 31.84% weight on energy, 29.1% weight on agriculture, 17.59% weight on industrial metals, 14.59% weight on precious metals, and 6.86% weight on livestock. There are two advantages to this iPath ETN. First, since it is an exchange-traded note (ETN), this product has the tax advantage over an ETF of not allocating any capital gains distributions to investors while they own the product. Second, this ETN can more accurately track its index since it does not hold and roll futures contracts and simply matches the return on the index. However, this product is an unsecured note issued by Barclays Bank PLC, which means that in the event that Barclays goes bankrupt, this ETN could be become worthless and an investor could lose his or her entire investment. Investors need to seriously consider whether they want to take on this additional risk by buying an ETN as opposed to an ETF. Lehman Brothers launched a set of ETNs just seven months before going bankrupt in September 2008 and investors who bought those ETNs will only get back pennies on the dollar in the Lehman bankruptcy process. The third largest commodity index ETP is the iShares S&P GSCI Commodity Index ETF, which has about $1.5 billion in assets. This ETF has a heavy weighting on energy at 66%, with only 19% on agriculture, 4% on precious metals, 6% on industrial metals, and 6% on livestock. Our opinion is that this ETF is too heavily skewed toward energy and doesn’t have enough exposure to the other commodity areas such as metals, agriculture, and livestock. We would avoid this ETF simply because of its heavy 66% weight on energy, unless you happen to be an investor who is particularly bullish on energy and specifically wants this extra exposure. The fourth largest commodity index ETP is the ELEMENTS Rogers International Commodity Index ETN (RJI), which has about $450 million under management. The weights for this index are broadly distributed among a variety of commodities, with a total of 44.0% on energy, 23.2% on metals and industrial products, and 32.8% on agricultural products (including softs and livestock). This is a broadly diversified index and includes such commodities as lumber, rubber, greasy wool, rice, canola, rapeseed, and azuki beans. We like the diversified nature of this index. This product, however, is an ETN and depends on the credit of its issuer, the Swedish Export Credit Corp (http://www.sek.se/en), which is not exactly a well-known global financial institution that is easy to keep tabs on. On the brighter side, the Swedish Export Credit Corp (Svensk Exportkredit AB) is owned by the Swedish government, which presumably means it is backed by the full faith and credit of the Swedish government and would not be allowed to fail. The fifth largest ETP is the GreenHaven Continuous Commodity Index ETF Fund (GCC), which has about $280 million of assets under management. This ETF tracks the CRB Continuous Commodity Total Return Index, which is an equally weighted index of 17 commodities. (As a side note, the CRB Continuous Commodity Index is owned and managed by Reuters; Barchart.com and its subsidiary Commodity Research Bureau have no relationship the CRB Continuous Commodity index or with the Greenhaven ETF and receive no financial benefit from mentioning this index or ETF product). In 2005, Reuters and Jefferies changed the Reuters/Jefferies CRB Commodity Index (Barchart.com symbol: $CRB) to give it a much heavier weight on energy. However, the old index survived and was renamed the CRB Continuous Commodity Index (symbol: CCI). As seen in Figure 6, the old Continuous Commodity Index has substantially outperformed the new CRB index since the split. Figure 6: Comparison of "old" CRB Continuous Commodity Index versus the "new" Reuters/Jefferies CRB Index (link to live chart)
The weights for the CRB Continuous Commodity Index are 29.40% for softs (cotton, coffee, cocoa, sugar, orange juice), 23.52% for metals (gold, silver, copper, platinum), 17.64% for energy (crude oil, heating oil, natural gas), 17.64% for grains (corn, soybeans, wheat), and 11.76% for livestock (live cattle, lean hogs). This index is ideal for investors who want to minimize their weight on energy because this index has the lowest weight on energy of any of the other major commodity index ETPs. However, it could be argued that this index places too high of a weighting on the softs complex at 29.40%. This index places a heavy 59% overall weight on agricultural products, which means that this is a good product for investors who are bullish on agricultural commodities or who already have metal and energy exposure elsewhere in their portfolio, for example by holding oil or mining stocks. This index deals with contango by averaging the second through sixth futures contracts, meaning the position in a specific commodity is spread out across multiple futures contracts and is not concentrated in the front-month contract. One problem with this ETF is that it has a high fee totaling 1.09%, which includes a 0.85% management fee and a 0.24% estimated futures brokerage fee. The sixth largest broad commodity index ETP is the UBS E-TRACS CMCI Total Return ETN (UCI), which has about $84 million in assets under management. UCI is designed to track the performance of the UBS Bloomberg Constant Maturity Commodity Index Total Return. This ETN appears to provide fairly good protection against the negative effects of contango by spreading its position in a specific commodity across five constant maturities from three months up to three years. This ETN has an attractive weighting scheme with 34% on energy, 27% on industrial metals, 5% on precious metals, 30% on agriculture, and 4% on livestock. The main downside of this product is that it is an ETN and depends on the creditworthiness of its issuer, UBS AG.Investment ConclusionsIn picking the best commodity index ETF, there are trade-offs regarding desired exposure to specific sub-sectors, the choice of an ETF versus an ETN, and fee levels. Figure 7 outlines the advantages and disadvantages of the major commodity index ETPs. Figure 7: Commodity Index ETPs – Advantages & Disadvantages
In choosing a commodity index ETP, we believe that an investor should first make the determination of whether he or she is willing to own an ETN where one could lose their entire investment if the financial institution that backs the ETN should go bankrupt. If you do choose an ETN, then our advice is to at least keep close tabs on that financial institution and get out of the ETN at the first hint that the financial institution may be running into trouble. Of the six top commodity index ETPs, three are ETFs and three are ETNs. Regarding the three commodity index ETNs, we are not strongly opposed to owning those products given that the backers include Barclays for DJP, the Swedish Export Corp (owned by the Swedish government) for RJI, and UBS for UCI. All these are currently strong financial institutions. However, we do not see the point of taking on additional risk when these ETN products, in our view, do not offer major advantages over the ETFs in the sector. The three largest ETFs in the commodity index sector are the iShares S&P GSCI Commodity Index ETF (GSG), Powershares DB Commodity Index ETF (DBC), and the GreenHaven Continuous Commodity Index ETF (GCC). We would first drop from consideration the iShares S&P GSCI Commodity Index ETF which, in our opinion, has far too heavy of a weight on energy to represent the broad commodity space. Powershares DB Commodity Index ETF (DBC) has the advantage of being the largest commodity index ETF, with the most liquidity and a standard fee of 0.75%. However, DBC has a relatively high weight of 55% on energy, only a 5.6% exposure on softs, and no exposure to livestock, which are unattractive features in our opinion. That brings us to the Greenhaven Continuous Commodity Index ETF (GCC). Figure 8: Performance of three largest commodity index ETFs (link to live chart)
We like the GreenHaven Continuous Commodity Index ETF (GCC) because of its broad and equal-weighted exposure to the entire commodity sector and due to the fact that it is an ETF as opposed to an ETN. The GreenHaven GCC ETF addresses contango problems by having a broad spread across expiration months. In addition, GCC performed the best of the three commodity index ETFs, as seen in Figure 8. The two draw-backs of GCC are that it has a relatively high exposure to softs of 29% and a relatively high fee of 1.09%. For our money, however, we think the advantages outweigh the disadvantages and GCC is our pick for the sector. For investors who are put off by Greenhaven’s relatively high fee of 1.09% and the relatively high weight on softs (or the low 17.6% weight on energy), our second pick in the sector is the Powershares DB Commodity Index ETF (DBC). As we mentioned earlier, this is the largest ETP in the sector with very good liquidity and a long track record, although it has a relatively high 55% weight on energy and likely has more exposure to contango problems than the Greenhaven product. Commodity Sub-Sector ETFsInstead of investing in a broad commodity index ETF as discussed in this article, investors can also put together their own commodity portfolio by buying separate commodity sub-sector ETFs. We will discuss ETFs that focus on specific commodity sub-sectors in a separate article. The largest commodity sub-sector ETFs are as follows with the assets under management in parentheses: Largest commodity sector ETFs:
Commodity Producer ETFsWe will discuss commodity producer ETFs in a separate article as well. Commodity producer ETFs invest in the stocks of companies that produce commodities. These ETFs are effectively a hybrid commodity/stock investment that provides investors with a way to gain exposure to commodities while staying within the stock asset class. From the Barchart.com/ETF Research Team Resources:
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