Understanding The New Copper ETF

Dec. 1.11 | About: United States (CPER)

By Michael Johnston

One of the latest innovations in the ETF industry came in the form of the first exchange-traded fund offering exposure to copper, one of the most widely used and heavily traded commodities in the world. The recently launched United States Copper Index Fund (NYSEARCA:CPER), which debuted earlier this month, is not the first exchange-traded product to offer investors access to copper; it comes along after two exchange-traded notes from iPath that focus exclusively on this natural resource. But the new fund from USCF is different from the other products on the market in a couple of key ways.

What Makes CPER Unique

For investors looking to bet on a jump in copper prices, exchange-traded products can represent the most efficient path. But it’s important to understand that not all ETPs are created equal–and to understand the impact of the differences between the various options. CPER is differentiated by both the structure of the product itself and the methodology used by the underlying index to achieve exposure to the target asset class.

Structure

Both the iPath Dow Jones-UBS Copper ETN (NYSEARCA:JJC) and Pure Beta Copper ETN (NYSEARCA:CUPM), the two existing copper ETPs, are structured as exchange-traded notes. That means that they are debt instruments issued by a financial institution, and as such exposes investors to the credit risk of the related bank (in this case, Barclays). CPER is structured as a limited partnership that actually holds copper futures contracts, meaning that there is no associated credit risk.

There are several aspects of CPER’s structure that are worth noting. First, there may be tracking error relative to the underlying index, since the portfolio manager must go out into the market to buy and sell the underlying holdings. Second, commodity ETPs that use the partnership structure will generally require investors to submit a K-1 come tax time, and may result in tax liabilities being incurred even if positions generally weren’t liquidated. Commodity ETNs, on the other hand, generally are reported on Form 1099s and will only be taxable when sold.

Methodology

While the structural differences of CPER might be appealing to those looking to steer clear of exchange-traded notes, perhaps the real appeal of CPER lies in the methodology employed by the underlying index. Whereas many commodity indexes are comprised of positions in predetermined futures contracts (e.g., front month and second month), CPER is “dynamic” in the sense that its allocation will vary depending on current market conditions.

When the market for copper futures is backwardated–meaning that long-dated contracts are cheaper than those close to expiration–the index will be split between contracts expiring in the next four months that exhibit the strongest backwardation. When copper markets are contangoed, however, exposure is pushed down the maturity curve to the following December; that strategy essentially moves the concentration away from front-month holdings that can result in contango-related return erosion.

So when markets are backwardated, CPER moves holdings to the contracts that result in the strongest winds at the back of this strategy. When the market for copper futures are contangoed, however, exposure is pushed out into the future into contracts that are generally less vulnerable to the impact of contango on returns.

Copper Potential

Exposure to copper isn’t for everyone; because it is used in a number of manufacturing activities, this metal can exhibit heightened sensitivity to the overall health of the global economy. Moreover, because all exchange-traded products that offer access to copper use futures contracts, some knowledge of futures-based strategies is a prerequisite to investing in these products.

For those looking to make a bet on the popular industrial metal, CPER is an intriguing opportunity. The structure is unique from other products on the market, and should appeal to those who want to avoid taking on credit risk. And the methodology of the underlying index is sound, adjusting the techniques employed to respond to current market conditions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.