United States Commodity Funds, the firm behind the innovative USCI, rolled out another product created through its partnership with SummerHaven this week. The new United States Copper Index Fund (CPER) will be linked to the SummerHaven Copper Index Total Return, a single-commodity index consisting of copper futures contracts traded on the COMEX exchange. The index is constructed and maintained with the goal of minimizing the adverse impact of contango on returns while utilizing futures contracts in the liquid portion of the futures curve.
The methodology behind the index is relatively straightforward, and based on observable market prices at the end of each month. First, at the end of each month it is determined whether the copper market is in backwardation or contango, and the annualized percentage price difference between the next-to-expiration copper futures contracts and each of the next four closest-to-expiration futures contracts is calculated. Based on these indicators, the portfolio can be constructed in multiple ways:
- If the copper futures curve is in backwardation, the index consists of the two contracts with the highest annualized percentage price difference (i.e., the most severe backwardation), with each weighted at 50% of holdings.
- If the copper futures curve is in contango, the index consists of positions in the two contracts with the highest annualized percentage price difference, each weighted 25%. Also included is a position in the nearest-to-maturity December copper futures contract that has an expiration further in the futures than any of the contracts eligible for inclusion in the index.
Currently, the copper market is in a state of contango, with November contracts trading at a discount of about 1.3% to December futures. Accordingly, CPER’s portfolio consists of positions in March 2012 and April 2012 contracts, each weighted 25%, as well as December 2012 futures contracts.
That “dynamic” approach is designed to minimize the impact of contango, which can erode returns to futures-based products when they are forced to essentially sell low and buy high when rolling positions to avoid taking physical delivery of the underlying commodity. The inclusion of the long-dated December contract when markets are contangoed will reduce the turnover of the portfolio, because that holding could remain intact for several months.
CPER is the third copper exchange-traded product available to U.S. investors, joining a pair of ETNs from iPath. The iPath Dow Jones-UBS Copper ETN (JJC), which has been around since late 2007, has about $150 million in assets under management. Earlier this year, iPath debuted the Pure Beta Copper ETN (CUPM), which is part of a suite of products that maintains the flexibility to “roll” exposure into a number of different contract months. Rather than allocating exposure in accordance with a pre-determined roll schedule, the Pure Beta methodology makes the decision based on observable price signals, including the slope of the copper futures curve.
CPER is structured as a publicly-traded limited partnership, while the existing copper products are exchange-traded notes. Those structural differences can potentially impact the risk/return profiles experienced in a number of different ways. First, CPER won’t expose investors to the credit risk associated with ETNs, which are senior debt instruments issued by financial institutions. But ETNs generally don’t experience tracking error or commission costs, which can potentially weigh on returns of products such as CPER. The tax treatment of these products will generally be unique as well. Investors in CPER will generally be required to fill out a K-1, while positions in commodity ETNs will be reported on a Form 1099.
“Contango Killer” Commodity ETFs
Exchange-traded products have become tremendously popular tools for establishing exposure to commodities in recent years, since these vehicles allow access to this asset class without a futures account. While the “first generation” of exchange-traded commodity products primarily included products that focused on front month contracts, innovation in recent years has focused on methodologies for mitigating the potentially adverse impact of contango on funds that rely on futures contracts to achieve exposure to the underlying natural resource. Generally, these strategies involve flexible roll yield capabilities depending on current market conditions and advanced algorithms. Many of the commodity ETPs launched from PowerShares/Deutsche Bank utilize an “Optimum Yield” approach, while iPath recently debuted its “Pure Beta” line of commodity ETNs. And as mentioned previously, USCF already offers the United States Commodity Index Fund, a broad-based commodity product that considers the degree of contango or backwardation in various futures markets when constructing a portfolio.
Disclosure: No positions at time of writing.
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