Proshares to Leverage Commodities 2 comments

by: Hard Assets Investor February 01, 2008

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ProShares has become the fastest-growing company in the ETF space by offering leveraged, short and inverse-leveraged ETFs covering the domestic stock market. The current slate of ProShares ETFs are designed to deliver 200%, -100% and -200% of the average daily return of a benchmark index; if, for instance, the S&P 500 goes up 1%, the related inverse-leveraged ETF should go down 2%.

Now, the company is looking to extend its empire to commodities. The company recently filed papers with the Securities and Exchange Commission [SEC] for the right to launch 24 new ETFs tied to the commodity markets. The new funds will include leveraged, short and inverse-leveraged funds cover each of the following markets:

Dow Jones-AIG Commodity Index
Dow Jones-AIG Precious Metals Index
Dow Jones-AIG Industrial Metals Index
Dow Jones-AIG Agriculture Index
Gold
Silver
Natural Gas
Oil

The commodity index funds track the price of the "excess return" commodity futures indexes, and include any and all "roll yield" from the position. As a result, these funds will be subject to the impacts of contango and backwardation.

The gold and silver funds, in contrast, will be tied to the price of physical bullion.

The oil and natural gas funds track the price of the relevant near-term futures contract, but do not include the roll yield.

Who will use these new funds? If history is any guide, a lot of people. The equity ETFs have gathered over $9 billion in assets in just 16 months on the market, as hedge funds, institutions and even retail investors have used them to tweak their exposure to the market.

A few things are worth noting about these funds.

First (assuming they launch), it is important to understand that these funds provide double the daily return of their benchmark, not double the long-term return. If gold goes up 1% today, the leveraged fund should go up 2%. But if gold rises 10% this year, there is no guarantee the fund will rise 20%. Thanks to the magic of compounding, the long-term returns do not match the 200% goal, and have tended recently to be more in the 120%-170% range. (For more, click here.)

Second, all of these funds benefit from interest income. The funds gain exposure to these markets through swaps, futures and other derivative contracts. Typically, you only have to put up a fraction of total assets to make investments in these categories, and the remaining money can be invested in Treasury notes gathering interest.

Finally, the short funds are particularly appealing because they generate interest income above and beyond the collateral interest mentioned in point 2. Because these funds sell swaps and contracts, they gain additional income that can push total yields very high indeed.

There are big risks with leverage and it is not for every investor, by any means. But still, these are interesting products and could be a nice addition to the commodities investment field.