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Commodity ETFs

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The past quarter has been an extremely rough one for commodity investors across the board, as concerns over global growth and a stronger dollar have conspired to push prices lower. Nevertheless, interest in the space remains high thanks to the diversifying powers of this asset class and the hopes for a return to strong performances should the economy pick back up in the near term. However, the commodity ETF space is chock-full of options, giving investors a number of different ways to play the space. While many are quality choices, a few stand out as potentially superior products thanks to their interesting methodology and approach to diversification. One such fund on this list is the United States Commodity Index Fund (USCI - ETF report).

Unlike many of the ‘first generation’ commodity products, USCI employs a more active, but still rules-based, approach to investing in the space. Each month, the index selects 14 commodities out of a possible 27 for inclusion in the basket. The first seven are selected based on backwardation of the futures curve; those commodities with the most backwardated contracts are included. The second half of the portfolio is based on performance; the seven best performing commodities over the past 12 months are included in the basket for the month. The commodities are then equally weighted and rebalanced on a monthly basis (read Where Are Gold And Silver Prices Headed Now?).

This technique is based on a wealth of research from the team at SummerHaven Investment Management which is constructed on a landmark paper from two Yale Professors, K. Geert Rouwenhorst and Gary B. Gorton. In their studies, the two professors found that prices were very dependent on inventory levels, backwardation, and visible metrics of the futures curve. They also observed that a commodity portfolio based on these statistics would crush a similar portfolio that is equally weighted over a long time horizon, suggesting that there might be significant data to back up these ideas.

This robust methodology is in stark contrast to other indexes in the space which are both passive and tend to be heavily weighted towards certain groups of commodities. In fact, two other popular commodity indexes—the Deutsche Bank Liquid Commodity Index Optimum Yield Total Return and the S&P Goldman Sachs Commodity Index Total Return—both devote more than half of their portfolio to the energy sector. While this may be a good way to do things for those focused on contract volume, one has to wonder just how true of a picture of the commodity world this gives investors. Instead, USCI has a basket that is (currently) just about 30% energy, 21% livestock, with 14% allocations going towards each of the following three sectors; softs, industrial metals, and precious metals (see CPER: A Better Copper ETF?).

In terms of performance, USCI was handily beating the other products to start the year, but the more spread out approach has crushed the commodity ETF in months past. From a YTD look, USCI has underperformed its counterparts in the space, (DBC - ETF report) and (GSP - ETF report), by a rather wide margin falling by 8.1% compared to an average loss of about 2.9% for the other two products. Unfortunately, much of this weakness can be attributed to USCI’s holdings of the ultra-volatile livestock and soft sectors which in times of commodity weakness, can often lead on the downside. Furthermore, energy products, thanks to turmoil in the Middle East, have held up surprisingly well, giving funds like DBC another reason to outperform over the time period.

Investors should also note a few other aspects of the fund which may be of interest to those seeking to learn more about the product. First off, the product is technically structured as a partnership so K-1s will be required come tax time, a potentially unpleasant issue that some might want to avoid by buying ETNs instead. Additionally, the fees on USCI, thanks to its inclusive approach and relatively active strategy, are quite a bit higher than others in the space with the expense ratio coming in at roughly 95 basis points a year.  

Nevertheless, USCI’s technique of buying up commodities that are in steep backwardation and looking to momentum definitely sounds promising and it has a wealth of data to back it up over the long term. Yet, while USCI certainly has a very interesting methodology, it is by no means guaranteed to outperform as investors have seen as of late. With that being said, the product certainly offers more in the way of diversification and could be a better pick for those seeking a long-term buy-and-hold strategy, assuming of course they can stomach the rather high fees. But to say that USCI is hands-down the best commodity ETF seems unwarranted, suggesting that there are a good number of options that can accomplish goals in this space and not just this upstart commodity fund from USCF (read The Best Commodity ETF For 2011 and 2012).

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