United States Commodity Funds rolled out another addition to its suite of “third generation” commodity ETPs this week, debuting a fund that will take a unique approach to delivering access to agriculture commodities.
The United States Agriculture Index Fund (NYSEARCA:USAG) will implement a variation of the methodology used by USCI, dubbed the “contango killer” commodity ETF, that debuted in 2010 and has accumulated about $400 million in assets. Instead of maintaining static weights to various agricultural commodities, USAG will seek to replicate an index that shifts exposure based on current market conditions.
Under The Hood
USAG will seek to replicate the SummerHaven Agriculture Index Total Return, a benchmark that consists of 14 agricultural commodities: Soybeans, corn, soft red winter wheat, hard red winter wheat, soybean oil, soybean meal, canola, sugar, cocoa, coffee, cotton, live cattle, feeder cattle and lean hogs. Each of those commodities is assigned a “base weight” in the underlying index that is determined from factors such as overall economic importance:
|USAG Base Weights|
|Soft Red Winter Wheat||8.0%|
|Hard Red Winter Wheat||4.0%|
What makes USAG unique, however, is the adjustments made to these base weights on a monthly basis depending on current market conditions. The underlying methodology is designed to overweight components deemed to be in a “low inventory state” and underweight those deemed to be in a high inventory state. Academic research suggests that the slope of the related futures curve can often deliver some insight into inventory levels. Backwardation often signals a relatively short inventory for a commodity.
In order to determine the allocations to the individual commodities, the index utilizes a three step process:
- The four commodities with the highest annualized percentage price difference between the closest-to-expiration contract and next closest-to-expiration are selected.
- From the remaining 10 commodities, the percentage price change of the closest-to-expiration futures contract over the previous year is calculated, and the three with the highest change are selected.
- For the seven commodities selected, each commodity base weight is increased by 2%. For the remaining seven commodities, the base weight is lowered by 2%.
Step No. 1 above essentially identifies the commodities with the most significant backwardation in the related futures curve (or most moderate contango). Step No. 2 identifies those commodities with the greatest price momentum over the last year. So the USAG methodology is constructed to overweight commodities with strong momentum factors or a backwardated futures curve, two features that may appeal to commodity investors.
By employing this methodology, the USAG portfolio will essentially be tilted toward commodities in backwardation or with strong recent performances, and away from those in steep contango or that have negative momentum. But it will always maintain at least some allocation to all 14 commodities.
With the launch of USAG, there are now eight broad-based agricultural commodities ETPs that offer exposure to this asset class through futures contracts. The most popular of the group, the PowerShares DB Agriculture Fund (NYSEARCA:DBA) has about $1.9 billion in assets. USAG is the only one of that group that employs the Summerhaven methodology. The other ag ETFs generally maintain relatively static weightings in individual component commodities.
'Third Generation' Commodity ETFs
The United States Commodity Index Fund (NYSEARCA:USCI) employs a similar methodology to construct a broad basket of commodity futures. That ETF selects from a universe of 27 natural resources and holds the 14 included in the underlying index. So that ETF employs an “all or nothing” approach. Individual commodities are either included or excluded based on the slope of the related futures curve and momentum factors. With USAG, those price signals are used to determine not whether an individual commodity should be included or excluded, but whether it should be overweight or underweight.
USCF also launched a copper ETF (NYSEARCA:CPER) that spreads its holdings along the futures curve based on price signals, and has plans for a metals fund that would employ an approach similar to that used in USAG.
Disclosure: No positions at time of writing.
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