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The reason many of us invest is to ensure our hard earned savings keep pace with inflation, or better yet, outpace inflation. Traditional investors are generally familiar with three broad categories of investment: stocks, (nominal) bonds, and cash. In the current interest rate environment, cash and most nominal bonds do a very poor job of compensating investors for inflation risk because they offer a fixed rate of interest. Alternatively, stocks historically compensated investors well over long periods of time, providing a rate of return comfortably in excess of inflation. That being said, stock investors can expect P/E multiples to contract initially during bouts of inflation, as the market takes time to digest the rising interest rates often associated with such periods. The (short-term) failings of the three traditional asset classes during periods of accelerating inflation leave many investors searching for alternatives.

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Beyond providing valuable diversification benefits in a portfolio context, commodities are an intuitive choice for inflation protection, as they often comprise a large share of the input costs associated with many goods and services. However, it is difficult for the average investor to obtain direct access to commodities. Commodities, as an investable asset class, were largely off limits to individual investors until the 1970s, when the establishment of the CFTC provided for pooled commodities structures, known generally as "managed futures." However, managed futures platforms are often relatively illiquid, expensive, and inaccessible to the average investor due to relatively high minimum investment requirements. In the last decade, as the ETF industry exploded, several ETF sponsors sought to solve this problem, by providing investors with exposure to commodities in the convenient wrapper of a fund structure that trades like a stock.

Funds that seek to mimic the price movement of commodities such as gold and silver, which can be stored with relative ease, have a distinct advantage; management can purchase the underlying commodity, put it in a bank vault, and then report the changing value. For other commodity funds, such as those seeking exposure to agricultural or energy products, storage is not an option. Rather than dealing directly in the underlying commodities, fund management must transact in the futures or "paper" markets to attempt to replicate performance for shareholders.

Investors seeking exposure to the upside of those commodities that cannot be stored must contend with the well-established contango problem. Contango occurs when long-term futures contracts trade at a premium to near-term contracts. Accordingly, the manager must liquidate a lower cost position and deploy the proceeds towards the purchase of a higher cost position. In other words, the fund is selling low and buying high. For an example of the contango problem, we can contrast the performance of the United States Oil (NYSEARCA:USO) fund with a measure of the price of oil over time (Source).

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Now that the market has come to understand the contango problem facing these ETFs, several fund sponsors are pursuing solutions applying rules based index construction to broad baskets of commodities. The charts below contain several of the more actively traded names in this space and a brief description of the underlying index construction.

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Included in the chart above are (NYSEARCA:USCI), (NYSEARCA:DBC), (NYSEARCA:RJI), (NYSEARCA:DJP), and (NYSEARCA:GCC).

In theory, these index constructions hit their mark, clearly outperforming a more passive commodity indexing strategy. Perhaps the most heralded of these strategies is the SummerHaven Dynamic Commodity Index, which serves as the benchmark for the United States Commodity Index . The SDCI is based on the notion that commodities with low inventories will tend to outperform commodities with high inventories, and that priced-based measures, such as futures basis and price momentum, can be used to help assess the current state of commodity inventories (Source). The index selects 14 commodities from a universe of 27 commodities across the six commodities sectors, subject to a ranking system measuring backwardation and price momentum. Backwardation is the opposite of contango; near-term contracts trade at a premium to long-term contracts. The index applies the price momentum criteria by assessing which commodities have experienced the greatest price increase over the previous 12 months. The index then applies an equal weight to each of the 14 commodities selected for inclusion as well as a diversification requirement to ensure each of the six sectors is represented.

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In practice however, the SDCI is proving to be an elusive target. The ETF seeking to replicate its performance has been unable to achieve that objective with any consistency. While we can certainly expect a degree of tracking error due to fund level expenses and transaction costs, the fund also falls victim to the contango problem, as the structure of the futures marketplace today causes most commodities to be in a seemingly chronic state of contango. As it stands, ­half of the 14 commodities currently included in the index are in contango (Source).

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At the expense of diversification, it may be worthwhile for the United States Commodity Index to consider restricting inclusion to only commodities in backwardation and likely discontinuing the price momentum criteria. In doing so, the fund could mitigate the adverse effect on performance of the negative roll yield.

Disclosure/Disclaimer: The ETF Authority is a team comprised of two independent financial professionals, Nathan Rutz and Kevin Prendergast. This article was jointly written by Nathan and Kevin. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. The opinions expressed in this article are those of the authors and do not constitute investment, tax, or legal advice. Please consider your specific risk tolerance and investment objectives carefully before investing.

Source: USCI, The 'Contango Killer' ETF: An Imperfect Solution