A Commodity ETF For All Seasons

Investors interested in the broad commodity market are faced with a wide range of choices. The two main differentiators between funds are the weighting of each commodity, and whether they implement a methodology that protects the fund from potential negative effects of rolling futures contracts. Understanding these differences is the key to picking the right fund for your investment needs, as funds with slightly different methodologies can have dramatically different returns. Today we'll profile one of our favorites in this broad-basket space:  GreenHaven Continuous Commodity Index , which offers an unusual and successful methodology.

GCC employs a unique strategy that allocates equally to 17 commodities. This may seem strange when compared with broad equity indexes, which usually weight by market cap. However, equal-weighting is a commodity indexing strategy with a long history; many important academic papers studying the returns of commodities as an asset class have tracked an equally weighted index. Commodity futures are a zero-sum game, meaning that every long position is offset by a short position. As a result, commodities have no market capitalization to weight by, and every index must pick a distinct strategy to follow. Most broad commodities funds weight their portfolios by economic significance, a proxy for market cap, which results in an energy allocation that can go as high as 70%. When investors buy these energy-heavy funds, the returns of agriculture and metal commodities are diluted with a small relative weighting. Not so with GCC, which is more than 80% nonenergy commodities like corn, sugar, and platinum.

Investing in commodities is not for everyone. GCC is most appropriate for two kinds of investors: those who believe global demand for commodities will grow in coming years, and those seeking diversification and an inflation hedge. Both types should understand that commodities are a high-volatility asset class. The former should keep an eye on demand from China and India, and the latter should manage their expectations.

Here’s why: historically, commodities have had low correlation with stocks and bonds, but that relationship has been tested in recent years. Investors should be aware that correlation to equities has been on the rise since the financial crisis. If stocks starts to decline, commodities are unlikely to keep a portfolio afloat because there is now an almost 80% correlation between the S&P 500 and the broad commodity index. Because investing in commodities has been effectively democratized through ETFs like GCC, it is unlikely that correlations will drop very far in the future. As an inflation hedge, commodities have usually underperformed during periods of low inflation, and outperformed during inflationary environments. Generally, commodities shine at the beginning of a recession and the end of an expansion.

Instead of owning huge warehouses full of corn and oil, GCC invests in commodities futures. These are contracts that require the holder to purchase a certain quantity of a commodity, at a predetermined price, delivered on a specific date. When a futures contract expires, the physical delivery of the product occurs. To prevent taking these deliveries, GCC “rolls,” which means selling the currently owned, close-to-expiration contract, and buying a contract of the same commodity that expires further in the future.

Rolling can produce two effects, called contango and backwardation. If the longer-term contract is priced higher than the expiring one, this is called contango and results in a negative return every time futures contracts are rolled. If the opposite occurs and the longer-term contract is priced cheaper, this is called backwardation and the fund makes money rolling contracts. The commodities market has been stuck in persistent contango for the last few years.

  - source: Morningstar Analysts

Because contango can eat up returns for a fund, GCC spreads out its contracts across the futures curve instead of just purchasing the front-month contracts. Each commodity is purchased through contracts spread across two to five of the next six delivery months. Some funds, such as large competitor  iPath DJ-UBS Commodity Index ETN (DJP), have no protection from contango. We prefer funds tracking indexes that pick and choose contracts to minimize contango.

Potential investors in GCC will have an investment thesis that rests upon a very positive outlook for future commodity demand. Economic and population growth in the emerging markets will continue to place greater strain on ultimately limited supplies of the world's natural resources. The U.N. projects an 11% global population increase by 2020 and a 20% increase by 2030. At the same time, the global middle class' surging growth will compound demand for food and energy as diets and transportation habits become more like the West's.

The largest threat to this story is a major slowdown within the emerging markets, namely China. The nation is a chief demand-side driver of virtually all commodities. The communist nation has staked its legitimacy on sustained 8% GDP growth and has engaged in a tremendous infrastructure binge to keep up the pace. If that pace slows and the "Chinese bubble" pops, the lightened commodity demand could provide substantial headwinds for GCCs commodity futures holdings.

Portfolio Construction
GCC tracks the Thomson Reuters Equal Weight Continuous Commodity Total Return Index, which provides the return of 17 different equally weighted commodities, plus the interest on Treasury bills serving as collateral. Metals, “soft” commodities (coffee, sugar), and agriculture make up about one fourth of the portfolio each. Energy comprises only about 18% of the fund, which is the lowest by far of its peers. The fund is rebalanced at the end of every day, which incurs brokerage fees. These fees are added on to the published expense ratio, so prepare to pay extra.

GCC is structured as a limited partnership, which means that investors will receive a K-1 form instead of a 1099 during tax season. Each year, GCC must mark to market its contracts, which in the eyes of the IRS is equivalent to selling them. Any gains made over the course of the year will be realized and passed through to investors. Each year, 60% of the gain will be taxed at the long-term capital gains rate, and 40% at the short-term rate, whether or not the investor has actually sold the fund.

Fees
GCC charges 0.85% every year, but also costs an additional 0.20% a year for brokerage fees. At 1.05% the fund is more expensive than its peers. Cost is a real drawback for GCC.

Alternatives
 PowerShares DB Commodity Index Tracking (DBC) tries to mitigate the negative impact of rolling. Instead of tracking front month futures, when it comes time to roll a contract the fund picks the one that will produce the most positive roll yield, up to 13 months off from the present date. DBC doesn't avoid the 60/40 tax rule that broad-basket commodity ETF investors must pay.

The most vanilla broad-basket commodities product available is  iPath DJ-UBS Commodity Index TR ETN (DJP). It tracks front-month futures, which are the ones most closely linked to the actual spot price of each commodity. Its path-dependent fees mean investors can be charged extra. DJP has not outshone its competitors, likely because the fund is unprotected from contango.

Because  iShares S&P GSCI Commodity-Indexed Trust (GSG) is weighted by economic significance, it is heavy with energy: almost 70% is energy commodities. This has resulted in higher volatility than its peers. GSG avoids the 60/40 rule by buying contracts linked to the return of 24 commodities, instead of buying the futures itself.

The newest offering is  United States Commodity Index (USCI), which has the most complicated methodology. Each month, 14 commodities are chosen out of a pool of 27 options. Using a set of rules, seven are chosen that minimize contango/maximize backwardation in the coming month, and seven are picked that do the same on a year-over-year basis. USCI is young, but it has performed well since inception and has experienced low volatility.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.