GSG: Can You Overcome Contango?

| About: iShares S&P (GSG)

Inflation risk - this is the main reason rational investors seek funds that track commodity exposure. No, it's not to play oil or bet against the Chinese, though many non-investors do in fact use these products for that reason. Don't get me wrong, you never really invest in commodities. You have exposure from time to time in an effort to hedge your portfolio from debasement of paper assets. If you try to "invest" in GSCI, the most recognized commodity index used to hedge inflation, there are a few issues: contango will ruin your day during times when too many investors want exposure to particular commodities, K-1, a simple but irritating tax document will cut into deserved profits, wasting time and sifting through ready-made products that promise concepts they can't deliver on.

Look at these two products Barclays put out: GSP and SBV. Both are coming out of the exchange traded note desk. These products promise what you want, what every wanna be future trader wants, MONEY, but, if you wanted to be a player you would trade the actual futures. However, this way is easier to track the index, and not worry about a lousy K-1 that complicates your goals. GSG, an ETF from Barclays will do the same thing as GSP but doesn't have the same streamlined tax qualities. My issue is not with GSP, but with the inherent issues of what is called contango. I asked the fine people at Barclays if they had anything that could address, if not solve the issue in general. They said they had a winner, SBV, an exchange traded note that could do just that. Before we get to the dotted line, two items need to be discussed.

First off, what's a K-1? A K-1 is a simple filing to the IRS used in documenting corporate income tax paid by the shareholders at the end of each fiscal year. By comparing two products where one carries the K-1 to one without it, it's easier to intuitively understand why. Conveniently we'll stick to GSG vs. GSP. GSG is an ETF Trust structured as a limited partnership which pools collected capital to invest in a large array of commodity futures. Thus when you purchase the ETF, you become a limited partner of the trust itself and are responsible for your proportion of income tax within the Trust. GSP on the other hand is an ETN structured as a product, not a Trust. In this way a percentage shareholder doesn't pay a portion of the income tax received each year, management does and is included in the fees of the ETN. Instead you claim a profit loss after the sale of your position.

Second, contango and backwardation matter. In short, contango is the infamous situation where your most recent contracts for the specified commodity trade lower than the next upcoming month. Your 2-month trades higher than the current, the 4th is even more, and so on. Worst yet, as the contract nears its expiration date, that premium will evaporate to the traded spot price, it's a lose-lose unless the commodity goes up more than the extra premium you paid. In reverse, backwardation is the process where near term contracts trade higher than those further out, and older contracts become cheaper and cheaper before swinging back to the spot price. In English, backwardation means you have value, and contango means you are in a momentum market, or simply one that is expensive to invest in. Oil over the past decade has seen a dramatic increase in contango, with signs pointing to higher institutional interest in buying oil futures contracts as a so-called investment. You still want to have exposure from time to time, but the cost grinds on your potential returns. Making it worse, futures have different expirations that make this phenomenon more complex than what an individual or professional investor may want to deal with.

So how does this come together for SBV? It's simple. The idea is this: the difference in cost going from the most current contract to the next, becomes less and less the further out you go while in contango. In backwardation it's the same thing, however instead of costing less and less, you're making less and less. In theory, if you maximize your exposure to short-term backwardation, and minimize the exposure to long-term contango, you're going to make more money than you lose.

"Barclays, help me! I want to trade this stuff, but this mean man is telling me not to buy your products, and I don't know what economics is." Their response to my frustration is to buy their ETN that tracks the Pure Beta GSCI Weighted index. Take a look at the numbers.



Pure Beta GSCI


Daily Average Return

10yrs or Inception

Last 10yrs


Since Inception 9/20/'06


Last 10yrs


Since Inception 4/28/'11


Total Return

10yrs or Inception




















Commodity Allocations











Industrial Metals








~4.7 %


Precious Metals





A few things jump out. Clearly over the last 10 years the Pure Beta Index has blown away the front-month dependent GSCI. The question should come to mind: why didn't Barclays issue a Pure Beta Index earlier? While I have data going back to 12/31/99, the index did not officially launch until 10/30/2009. Since that 'live' date Pure Beta Index versus GSCI is +0.02% and -3.75%.

So, what is this fancy index really doing? I would reference the prospectus, but let me summarize. Barclays is simulating a front year, versus a front month. My criticism is that they use a proprietary methodology. That being said, they do go through quit a bit of their methodology that I think is reasonable. While not a black box top secret formula, we don't have the transparency of the GSCI. Some investors would love that. I for one hate the thought of traders front running GSCI rebalancing programs. However, we don't know if this back tested performance and three year track record will persist over time. Anything good will decay.

It's important to remember GSP doesn't work to solve the contango issue. It's only objective is track the GSCI without handing you the K-1. This appears to do quite well given how it is structured. SBV has similar weights and attempts to match the price action of a basket of commodities with out the distortion of contango or backwardation. The bottom line: I think we need to consider this as a compliment to products that seek to track the GSCI. How much? I don't know. The main risk is model risk. If tracking error to the GSCI is important, just stay away. If you are more intrepid and seek a cure for your front month conundrum then Barclays claims to have the secret.

Co-written by Gerald Gale

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

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