The Right Commodity Basket for the New Rules

If I were an exchange-traded fund provider, I might consider this a good a problem to have. While the industry is still in its relative infancy, discussions have already taken place in the regulatory realm claiming that commodity ETFs have attracted too many assets. And in some cases, the regulators are probably right.

Most of the hubbub is focused on  United States Natural Gas (UNG), which had to stop issuing shares in July after the Commodities Futures Trading Commission began strictly enforcing its position limit rules across all market participants. Simply put, UNG itself had grown so large so quickly that it became the largest investor in the front-month contracts for natural gas futures. This is problematic because the fund is a passive rules-based instrument that will systematically sell all those contracts when they near expiration in order to purchase the next contract, and all that volume occurs over a five-day window. One could argue that UNG itself is responsible for the prolonged state of contango in natural gas markets. For better or worse, the fund itself is likely impacting market prices in a pronounced manner.

The Senate, CFTC, and several other regulatory bodies are investigating whether UNG, and all other futures-based commodity ETFs, are responsible for some manipulation in these markets. Whether or not investors' intentions are malicious, we think that this review should prompt commodity investors to change their investing strategies, especially those who have purchased commodity funds for asset-allocation purposes. After all, these actions have already led to the liquidation of one exchange-traded product.

We previously favored larger, more diversified commodity basket ETFs to fulfill the commodities portion of a balanced portfolio. We still think the two necessary components of a portfolio are a solid mix of stocks and bonds whose weightings reflect the unique circumstances of each individual. Despite their lackluster long-term returns, adding commodities to a portfolio can be beneficial over the long haul because of their negative correlation with equities and bonds and high correlation to inflation. If these funds weren't up against their position-size limits, we'd still feel that way today. But today's environment has led us to modify that view.

We still favor a diversified set of commodities. At a bare minimum, the fund should have exposure to each of the following: energy, industrial metals, precious metals, and agriculture. Approximately two years ago, our top choice for long-only commodity exposure would have been  iShares Dow Jones UBS Commodity Index Total Return ETN (DJP) because it tracks 19 different commodities across all of the relevant commodity sectors. However, exchange-traded notes are not backed by assets as they are merely promises from banks to pay the return of the underlying index. When the financial crisis took hold, investors had good reason to flee from ETNs despite some of their tax and tracking advantages over commodity ETFs.

That led us to what we deemed to be the next-best alternative:  PowerShares DB Commodity Index Tracking ETF (DBC). Because this is an ETF rather than an ETN, it actually holds the futures contracts of the commodities in a custodian account. However, its shortcoming is that it tracks only six commodities: crude oil, heating oil, aluminum, gold, corn, and wheat. While these commodities touch all four of the relevant commodity sectors, a more-diversified set of commodities would provide slightly better diversification. We chose this fund despite this shortcoming because of its credit security and deep liquidity.

Liquidity matters in ETF investing because it helps investors get the best price. With more than $3 billion in assets invested in DBC today, investors can be fairly confident that their trades will be executed at a fair price, or close to the net asset value of the commodity contracts held, under most market conditions. However, substantial liquidity today now comes with a downside; because of the regulatory review, the larger the commodity ETF and the fewer commodities tracked by the index make the fund more subject to position limits on the commodities it tracks. While DBC appears safe today, it is not too far from hitting its limits on some commodities if the fund continues its torrid growth rate.

To mitigate this issue, we set out to find a commodity ETF that was both liquid enough to trade efficiently while remaining small and diversified enough to avoid regulatory scrutiny. We believe we've found the best answer with GreenHaven Continuous Commodity Index ETF . First, it passes the liquidity hurdle by having nearly $150 million in assets. We believe that market and authorized participants can make an ETF trade effectively after it has gained more than $50 million in assets. Second, the fund covers a broadly diversified set of 17 commodities that cover all four of the primary commodity sectors. And because the fund maintains an equal-weight position across these commodities, investors don't have to worry about having too much energy exposure (an issue that has been raised regarding other commodity ETF baskets). In fact, one could argue that this fund's weighting in energy is too light.

Finally, and a point that is really the icing on the cake, this fund does not concentrate itself on any single-month's contract along the futures chain. It owns balanced portions of each of the first six months of contracts rather than just the front-month or the 12th month contract. This serves to minimize the concentration of its holdings in any single contract, which both minimizes the fund's market impact and its likelihood of approaching regulatory limits. In fact, we believe the fund could grow 10 to 20 times larger without being suspected of "manipulation."

This fund would have been one of our favorites a year ago had there not been some downside to it. First, while its liquidity is sufficient, it's not yet in the same ballpark as DBC. Also, it's not the cheapest option available. With a 0.85% management fee and estimated futures brokerage fees of 0.24%, this ETF could cost you 1.09% per year. While this is price competitive with comparable mutual funds, it's one of the most expensive ETFs on the market. Finally, while the equal weighting and daily rebalancing are good for minimizing market impact and regulatory scrutiny, investors may want to supplement the exposure with a separate energy commodity fund if their optimal weightings differ from the index's.

 

 

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