By Brad Zigler
It seems all of my end-of-summer barbecues invariably result in a bout of backyard braggadocio about investments. Not that I invite it, mind you; it just happens. This week's get together featured more plaints than posturing, as my acquaintances invested in commodity index exchange-traded funds groused about their funds' poor performance.
"If commodities are doing so well," grumbled Medium-Cheeseburger-Hold-the-Onions, "how come I'm not making any money?"
"Yeah," carped Spicy-Linguica-Lots-of-Mustard, "I was supposed to earn twice the market return. Instead, I think I earned less than the index!"
I must admit that my explanations, punctuated with bites of potato salad, lacked the numerical foundation of my typical HAI articles, but one can only do so much without a whiteboard. For the record (and the further edification of charbroiled investors everywhere), let me elucidate fully.
Four Commodity ETFs: Side By Side
First, a little stage setting. The backyard complaints were made about exchange-traded funds, not notes. ETFs and ETNs, while similar in many ways, are plainly different vehicles for obtaining index exposure. Apple and oranges there, so we'll look only at ETFs in this analysis.
By the grill, we discussed four broad-based commodity index ETFs:
- The PowerShares DB Commodity Index Tracking Fund (DBC), which is based upon the Deutsche Bank Liquid Commodity Index - Optimum Yield Excess Return (Index), a benchmark composed of six of the most heavily-traded futures contracts in the world;
- The iShares S&P GSCI Commodity-Indexed Trust (GSG), which tracks the S&P GSCI Total Return Index (a variant of the former Goldman Sachs Commodity Index), a production-weighted group of two dozen commodity futures;
- The GreenHaven Continuous Commodity Index Fund (GCC), whose benchmark is the current iteration of the equal-weighted successor to the Commodity Research Bureau Index, a portfolio comprising 17 commodity futures
- The ProShares Ultra Dow Jones-UBS Commodity Index Fund (UCD), which attempts to offer twice the daily return of the Dow Jones-UBS Commodity Index, a simulation of a 19-commodity portfolio.
If there were an overhead projector available, we could have regarded a colorful depiction of the ETFs' year-to-date performance that would have looked like this:
Broad-Based Commodity Index ETFs
It seems as if whatever distinctiveness a fund exhibited early in the year eroded as time passed. The performance characteristics separating the funds in the spring appear to have been largely mitigated by the time fall rolled around.
While there's only a 6.11% absolute top-to-bottom performance differential, the spread's quite significant in relative terms; after all, GCC's return was three times that of DBC. What accounts for the performance dispersion among these funds?
Basically, it boils down to the three C's: composition, contango and compounding.
The Impact Of Oil Exposure
GCC's outsized performance is due in great part to compositional factors. The fund is equal-weighted, meaning each of its 17 futures components hefts 5.88% of the index load. The other indexes are production- or demand-weighted, to one degree or another. DBC's weighting scheme is the most intensely concentrated: Just a half-dozen of the most actively traded futures populate its portfolio.
That said, the heavyweight in these portfolios is crude oil. Currently, crude accounts for more than 37% of the PowerShares DBC fund, while the iShares GSG product is based upon an allocation of over 39% to crude oil. Oil's weight in the ProShares UCD fund is 18%. But in the GreenHaven GCC fund, oil's allocation is less than 6%, and it's no bigger than any other in the portfolio.
With spot oil up 60% on the year, you'd think the larger a fund's exposure to crude, the better its performance would be. So how come the fund with the smallest oil allotment has outgunned the other funds?
That brings us to the second C in our triad: contango. Contango's not a skin condition, though it does cause a fair amount of itchiness among traders. It describes the tendency of back-month futures to trade at a premium to nearby deliveries. Contango reflects the carrying charges, or the costs of financing, insuring and storing a cargo until the delivery date specified by a futures contract. When there's abundant supply of a commodity, there's plenty to carry into the future.
It should be no surprise to you that demand for crude has tumbled over the past year. As a result, supply has backed up and the oil market contango has swelled to record highs.
For futures traders, contango's a cost of doing business. An index fund, obliged to maintain constant exposure to its portfolio components, must periodically roll its long positions forward when its futures approach expiry. That means selling the nearby (and, in a contango market, the lower-priced) contract and buying the higher-priced deferred delivery one.
Buy high, sell low is not a recipe for profit, and each roll in a contango environment eats into any amassed profit. Thus, the steeper the contango, the greater the disparity between an ETF's performance and the spot commodity return. Keep in mind that, at one point this year, the three-month roll in crude oil would have cost an investor 40%.
So, the greater a fund's exposure to this carrying-charge market, the greater its return attrition, rather than accretion.
UCD Hit By Compounding Returns
That brings us to the third C: compounding. Compounding accounts for the rather tepid performance of the ProShares UCD portfolio, which aims to deliver twice the daily performance of its underlying index.
Even if UCD were perfect—that is, it produced no tracking error—in yielding two times the Dow Jones-UBS Commodity Index day to day, the compounding of returns produces greater effects, much like the magnifying power of a telescope lens. Both upward and downward returns are supersized.
For example, imagine buying UCD shares at $20 just ahead of a five-day run of 1% gains. Compounding the returns over five days (found mathematically as: $20 x 1.01^5) would put UCD at $21.02.
That's 2 cents more than just a simple 5% accretion ($20 x 1.05). Stretch that out over 180 trading days or so, and you've got a real disparity. Now make the daily returns negative, and the under-performance becomes equally dramatic—the compounding effect in reverse.
So, there you have it. The ABC's of commodity-index ETF returns really boil down to the three C's.
Now, pass the mustard, please.