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By Dave Nadig

Does Jefferies’ new Wildcatters ETF (WCAT) offer a better mousetrap, or just a riskier one?

Whenever a new ETF comes out, one of the first questions that pops into my mind is, gimmick or real deal?

With 900+ ETFs on the market, there are quite a few gimmicks out there: funds launched based on shoddy backtested data that are designed to capitalize on a hot moment in the markets, rather than to give investors a real, new, viable option for their portfolios.

But there are also plenty of ETFs that have delivered real benefits, including some that looked at first like gimmicks. Thematic ETFs like clean energy and infrastructure, for instance, were once scoffed at, but now are taken seriously by many investors.

The Jefferies | TR/J CRB Wildcatters Exploration & Production Equity ETF intrigued me at the outset for a number of reasons.

First, a few weeks ago, I moderated a panel on commodities at the 2010 Inside ETFs conference. One of my three panelists was Satch Chada, managing director at Jefferies Asset Management LLC.

Satch presented some data from his research suggesting that, historically, the best way for investors to emulate spot commodities prices was to buy a combination of commodity futures and commodity- producing stocks. (Graham Tuckwell, founder and chairman of ETF Securities, responded with “poppycock.”)

But Satch’s words resonated with the launch of WCAT, because there are a lot of investors out there who expect the spot price of natural gas to rise, and they’ve been searching for a way to play it. The two leading choices—the futures-based U.S. Natural Gas Fund (NYSEARCA:UNG) and the stock-based First Trust ISE-Revere Natural Gas Fund (NYSEARCA:FCG)—haven’t been doing a perfect job.

Maybe WCAT would, or at least provide a tool to get there. After all, that was what Satch was on about at the conference.

Let’s start with some basics: Two-thirds of the holdings in WCAT are natural-gas-focused exploration companies. The beauty of ETFs is that you know exactly what you’re getting, and in this case, it’s a combination of mid- and small-caps. The largest holding, Forest Oil (NYSE:FST) isn’t exactly a fly-by-night operation, with a $3 billion market cap and trading 3 million shares a day. The smallest holding, Iteration Energy [TOR: ITX], is definitely small, at just over $250 million. But unlike a true micro-cap play, even ITX trades millions of shares a day. The liquidity of the underlying (contrary to prognostications by Don Dion), is unlikely to be a real issue should investor demand drive a pile of creations.

Does WCAT get you spot?

In a word: Nope.

click to enlarge

WCATI/Nat Gas Henry Hub Index/UNG Performance - March 2009 - Dec 2009

Not only is WCAT different than investing in UNG, it’s quite different than investing in actual spot natural gas at the Henry Hub in Erath, La. (that middle line). Indeed, the three products are hardly correlated at all.

Interestingly, almost as Satch predicted, just eyeballing the chart suggests that with a 50-50 portfolio that mixed stocks and futures, you stayed much closer to spot gas than you did with either product on a stand-alone basis (I plan on tracking such a portfolio using the actual ETF data going forward).

But is WCAT different enough from competing funds to justify using it in a portfolio? To figure that out, I compared WCAT—or rather, its index data—with FCG; the SPDR S&P Oil & Gas Exploration & Production (NYSEARCA:XOP), the (nearly identical and uncharted) iShares DJ US Oil & Gas Exploration & Production (NYSEARCA:IEO); and even the PowerShares Dynamic Energy Exploration & Production (NYSEARCA:PXE).

FCG/XOP/IEO/PXE Performance: March - Dec. 2009

It should be obvious from the chart that WCATI is almost perfectly correlated to the other ETFs. But what stands out here is the strong performance: WCAT has crushed the competing funds over the past 10 months—since that March low we often use as the root point on our charts. It’s done so, we might assume, because it invests in small-cap companies, effectively levering up the risk of its core portfolio.

Is the substantial outperformance suggested by WCATI worth the additional risk?

Because I’m a wonk, the way I answer these questions is with statistics; in this case, the first stop is the Sharpe Ratio. Sure, there are more sophisticated tools out there, but the beauty of using Sharpe for something like this is simplicity. Sharpe ratio looks at the volatility of a pattern of returns, and the risk-free rate of return. It’s a relatively simple calculation, and it lets you compare the risk with the return of any two securities.

Here’s the Sharpe Ratios for the indexes/funds in question (using one year of weekly data):

WCATI: 2.07
XOP: 1.24
FCG: 1.24
PXE: 0.80

... and for good measure:

SPY: 1.56
IWM (the Russell 2000 Small Cap iShares ETF): 1.53

Now, I will say that this has been a unique year—a year marked by a blistering recovery, where the market has consistently and aggressively rewarded risk. But at the same time, I think it worth pointing out that the Russell 2000 is NOT showing that risk/benefit over the S&P 500. In other words, if you trusted the numbers completely (never a good idea), you would say, “small caps aren’t giving you more return for increment of risk compared with the S&P 500).

But at least in this environment, WCAT does look to at least be based on a better mousetrap. It’s ever so slightly more risky than FCG, its nearest competitor (its semi-variance—that is, the volatility of downside performance vs. mean performance—is 53.61 vs. 50.78), but thanks to Bill Sharpe, we can say with some certainty that that volatility has been well rewarded more often than not.

So how do I answer the question, is WCAT a gimmick or a legitimate new tool? I’d lean toward the latter. At a minimum, it provides a leveraged version of the popular FCG fund, and another way for investors to play natural gas prices. And, at least in some environments, it actually manages to capture higher risk-adjusted returns.

That’s the kind of ETF innovation I can get behind.

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Source: Jefferies' New Wildcatters ETF: A Better Mousetrap