Making Sense of Commodity Products

By Brad Zigler

Bigger is not necessarily better. Oh, sure; you'll always want bigger returns, but what about downside variance or bid/ask spreads? Those you'd want to be as small as possible, wouldn't you?

Investors considering a portfolio allocation to commodities for the first time are being tempted by an ever-widening assortment of competing products. Just this month, for example, a flotilla of Bloomberg/CMCI exchange-traded notes was launched. Just how do you select the right exchange-traded fund or note to place in your portfolio?

First things first. Let's look at the choices you now have to gain broad-based commodity exposure:

Dow Jones-AIG Commodity Index: This index can be accessed through a Barclays Bank-issued iPath note (NYSE Arca: DJP). Made up of 19 futures weighted primarily for trading volume and secondarily based on global production, energy carries the topmost weight, followed by metals, agriculturals, soft commodities and livestock.

The S&P GSCI is a production-weighted benchmark of two dozen commodities adjusted for liquidity and investability. Currently, the S&P GSCI is most heavily weighted in energy products. Investment in the index can be proxied through a Barclays Global Investors-managed iShares fund (NYSE Arca: GSG), an iPath note (NYSE Arca: GSP), or, in modified form, through an ETN issued by Goldman Sachs (NYSE Arca: GSC).

The Deutsche Bank Liquid Commodity Index: Comprised of only of six commodities, all purported to be the most liquid in their respective sectors, DBLCI is most heavily weighted in energy, then agriculturals and metals. There is no exposure to livestock or softs within DBLCI. A dual rebalancing policy is designed to maximize the return, or minimize the costs, of rolling futures forward. DBLCI underlies the PowerShares DB Commodity Index Tracking ETF (AMEX: DBC).

The Rogers International Commodity Index, the broadest and most international of the benchmarks, consists of 35 commodities. Weights are determined by a commodity's importance in international trade, with energy weighted most heavily, followed by agriculturals, softs, metals and livestock. An ETN tracking RICI (AMEX: RJI) is offered under the ELEMENTS brand.

The Continuous Commodity Index is, in fact, the original Commodity Research Bureau Index. The index is made up of 17 equal-weighted futures contracts. Sectorwise, agriculturals and softs are the heftiest, comprising nearly half the benchmark's weight. Metals make up about a quarter, with energy and livestock splitting the balance. The GreenHaven Continuous Commodity Index ETF (AMEX: GCC) provides access to the benchmark.

The Lehman Brothers Commodity Index Pure Beta Total Return Index, the basis for an ETN bearing the Opta marque (AMEX: RAW), is comprised of 20 futures contracts weighted most heavily to the energy sector, followed by smaller exposures to metals, agriculturals and livestock. The index dynamically underweights and overweights sector allocations to maximize roll yields.

The UBS Bloomberg Constant Maturity Commodity Index can be accessed through an ETN issued by UBS (NYSE Arca: UCI). The index tracks the returns from a basket of 28 commodity futures covering the energy, metals, agricultural and livestock sectors. Component futures are diversified across five constant maturities ranging from three months up to three years.

Now for the fun part.

Product selection starts by identifying those features most important to you. If you think seasoning, cost, liquidity, return and volatility are critical, construct a grid showing the appropriate raw data:

 

 

Each metric, i.e., bid/ask spread size, return, etc., should then be weighted for its relative importance. If current returns are most important, you might, for example, assign a weight of "10" to the category. Equal importance given to average daily volume would be signified with the award of a "10" to that category, while the assignment of an "8" to the downside variance metric denotes a characteristic of lesser importance. The weighting scheme is entirely personal. There's no "right" or "wrong" system.

Next, assign a ranking order, 1 through 9, to each of the nine products in each category according to its attractiveness. The product with the tightest spread, for example, would earn a "9" for being most attractive while the fund with the highest fees would warrant a "1" as the least attractive choice. When a category has products with identical characteristics, assign a priority to those products consistent with your overall investment preferences. For example, if you prefer seasoned over untested products, ties would be broken in favor of the investment with the earlier inception date.

Complete the matrix by multiplying each ranking order by the category weight. For example, a "9" in the expense/fee category, which is weighted as "6," earns the product a "54."

Then, simply tally the results across each product's row to arrive at a total. The highest score denotes the most attractive product.

 

 

With these parameters in mind, the Powershares DBC ETF, with a score of 336, fits your investment demeanor best.

 

Comments

[StateofConfusion]

This article puts a lot of reasons for selecting an ETF in perspective. Personally I don't give much weight to the spread as i would buy at a certain price only if I think there is a good chance of a large gain over the coming year. I own some DBC as it includes Ag and Energy.
some say to own real assets like silver but beyond owning a small amount of this (like silver quarters) I question if this is of any worth. If the futures market failed, would there still be food on the store shelves and would owning SLV make any difference? Could some deeper financial genius comment on that?