Paul Justice: Hi, there. I am Paul Justice, Director of North American ETF Research at Morningstar. Today, I'm here to talk to you about the ever evolving landscape of commodity ETFs, whether it be the proliferation of products or the evolution of the strategies in which they employ. I'm joined today by Ben Johnson, one of our ETF analysts.
Thank you for joining me, Ben.
Ben Johnson: Thanks for having me, Paul.
Justice: Well, we saw an interesting product that was just launched this week that really throws a wrench into the commodity landscape as far as recognizing these horrible returns investors have gotten from contango effects, which is fairly complicated matter that people need to understand when they're buying these ETFs in the first place. But people still focus on the fact that they want to have commodities in their portfolios to diversify or an inflation hedge. Could you talk a little bit about the methodology of this fund and why it actually addresses some of the issues that are pending on the market today?
Johnson: Sure. So, again the problem that's plagued a lot of long-only commodity futures strategies is, as you stated contango. So when I look at the futures curve for say, oil, current futures prices are lower relative to futures prices further out along the curve. So every month those long-only futures strategies are being forced to sell a relatively low priced futures contract, and then roll into or buy a relatively high priced futures contract.
Justice: That's relative to the price that it should be in a natural market…
Justice: – as far as cost of storage and everything else, and we had seen this persisting for the last five years.
Johnson: Correct. Contango has been persistent across the majority of commodity futures markets, so obviously this has been eating into the returns of long-only futures strategies and in turn, the ETFs that invest in those strategies.
Justice: Sure. So we've seen wide departures from – you know, spot prices going up 20%, while futures based funds going down 40%, which has been a very unpleasant experience for anybody who thought that they were getting this diversifier that would kind of follow the spot market, given that diversification that they were seeking. So we look at the broad basket commodity ETFs, and I think these are some of the worst performers in this regard. Granted they diversify across a bunch of segments, but like you mentioned before, I think, 22 out of 28 commodity markets that we look at are in this contango state or the poor roll yield return states. How does this fund address that issue, the USCI Fund?
Johnson: Yeah, the United States Commodity Index Fund tracks a strategy, the SummerHaven Dynamic Commodity Index. Now this is what I'll call an intelligent long-only index. So the methodology implies that this fund will look at 27 separate commodities spanning six separate sectors, and it will look across those commodities and it will do a few sorts. So the first sort it will do is it will select the seven of those 27 commodities that the futures market is current in either the steepest backwardation. So spot prices are higher than the further dates out along the futures curve or the sort of least bad situation being…
Justice: The least painful.
Johnson: – the most minimally sloped contango in a given futures market. It will select those seven commodities, and those will be included in the index. Now the next sort is a bit of a momentum sort. So it looks at the trailing 12-month return on the front month futures contract for the remaining 20 commodities that we're looking at, and it will select the seven best performing commodity futures over that trailing 12-month period.
What we're ultimately left with there's some further sorts to make sure that all six sectors are represented in the index at a given time. But ultimately what we're left with is a more intelligent index that's seeking to either minimize the negative effects and negative roll-yield associated with contango in the futures market, or alternatively to maximize the positive tailwind from backwardation in the futures market where we would be selling high priced contracts and rolling into relatively low priced contracts.
So we have at the end of the day 14 of the 27 original commodities that are eligible for inclusion and that is an equally weighted basket. So they're not giving preference to one of those contracts over another, and that basket is rebalanced on a monthly basis.
Justice: Now does this mean that we've kind of solved much of the contango problem or should we be looking at maybe ETFs that are still dwelling just in the spot market for the time being till we see more normalization in commodities markets?
Johnson: Well, it's going to be difficult to ever avoid the contango problem entirely. Again, not just a few months ago, we saw that the vast majority of these commodity markets were all in contango to varying degrees. So it's not completely inescapable. Is this a better alternative to a traditional sort of unintelligent, I'll say, long-only futures strategy in the commodity space? Absolutely, I think, it's an improvement. Will it completely avoid any sort of contango-related negative roll-yield? You can't rule that out.
Justice: Yeah. Now I'd say, the only way you're going to avoid that is either staying out of the commodity space or employing a commodity trading advisor or CTA to help you manage through those issues. But this is the closest thing that we've seen in the ETF space to replicate the CTA.
It looks like an active fund. Granted, it's based on a quantitative strategy, but there are very solid factors that they're basing it on, and the same things that the CTA themselves would be looking at. You just don't have the human override and hence you get a lower fee.
Johnson: Absolutely, and at 95 basis points, the fee on this fund is high relative to most ETFs, but I don't think that's necessarily a fair comparison when you consider that most other access vehicles to this sort of strategy are going to be some sort of very large managed futures account that may have a minimum investment requirement, a higher annual fee, and won't have the intraday liquidity benefits that are offered by an ETF.
Justice: I'll tell you, I'll take a strong look at the fund. For my money right now I'm going to stick in gold for my commodity exposure. So I don't have to worry about any of these impacts. But thanks for joining me today.
Johnson: Sure, thanks for having me.
Justice: And thank you for joining us today. For this and more ETF news, please check out our ETF Investor Newsletter or the ETF Solution Center on Morningstar.com.