Look Before You Leap Into New "Smart Indexes"

| About: GS Connect (GSC)

Institutional investors are "smart money," right?

Sometimes I wonder. Last week's Financial Times included a well-written article by Javier Blas reporting from the Commodities Week conference in London. The big news from the conference, according to Blas, is that pension funds are looking for increasingly sophisticated exposure to the commodities market.

"The pension funds said that on top of passive investment in market direction—providing what is known as a beta return—the industry was now eager to capture the skills of individual managers in an attempt to outperform—or alpha return," Blas writes.

According to the article, managers started looking at alternative approaches to long-only commodity indexes after popular long-only benchmarks like the S&P GSCI took it on the chin last year: The GSCI fell 16 percent in 2006, despite generally strong commodity prices.

According to Blas, these sorts of results have fueled "a growing demand for tailored commodities indices, in particular shifting the investments into more long-dated futures contracts and changing the allocations among different sectors, such as energy, base metals and agricultural commodities."

There are a few things that are curious about this statement.

First, the exchange-traded fund (ETF) industry is leading the way. There was a time when the great calling card of ETFs was that they brought institutional-style strategies to the retail investors. But look now: ETFs are leapfrogging institutions and developing smart products that anyone can access months and years before pension funds even know what they want and need.

For instance, ETF developers in the U.S. and Europe have been actively developing long-dated futures funds, such as Victoria Bay's 12-Month Oil Fund in the U.S. (which blends the next 12 months' worth of oil futures into a single fund) and the out-month ETFs from ETF Securities in London (which provide commodities exposure 1, 2 or even 3 years out the yield curve).

More recently, "smart indexes" have been developed that take advantage of unique pricing trends, like the GS Connect S&P GSCI Enhanced Commodity Total Return Strategy Index ETN (NYSEARCA:GSC) from Goldman Sachs, which uses seasonal and other pricing trends to achieve a higher return on their investments.

The ETF industry is reacting very, very quickly to changes in the commodities market, and is flooding the market with products designed to meet investors' needs.

The bigger point, however, is that the pension funds are too late to the game to change course on their strategies. The time to look into alternatives to long-only indexes was 2006, not 2007.

As we've highlighted repeatedly, the reason investors got burned in long-only commodity indexes last year was because of the vicious contango in the energy markets.  But that contango has reversed markedly, and we are now in a steeply backwardated market. That means the long-only, front-month futures indexes are looking good ... and all these efforts to move out the yield curve are looking less attractive.

Investors who switch out of long-only commodity indexes today and into out-month indexes will get the worst of both worlds: They will have suffered from last year's contango, and they will miss out on this year's backwardation.

Contango and backwardation are complicated concepts, but the guys running these funds should know better by now.

• More on Commodity ETFs and ETNs