The Academic Commodity ETF

| About: United States (USCI)
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By Abby Woodham

Strategies that eschew traditional market-cap weighting are the current trend in exchange-traded funds. Funds that use fundamental indexing or other rules-based weighting methodologies are popping up in almost every sector. In the commodities space, there's United States Commodity Index (NYSEARCA:USCI), which launched in 2010 and uses market-price signals to construct its index. Most commodity indexes weight by consumption or production, but USCI's strategy is based on research by academics Geert Rouwenhorst and Gary Gorton. In a 2007 paper, Rouwenhorst and Gorton found that the futures contracts of commodities with low inventory consistently outperformed those of commodities with high inventory. They also found that selecting commodities for momentum, a risk factor that has garnered increased interest in recent years, boosts return. The index that USCI tracks seeks to capitalize on these observations, but the fund's live performance record has been below average compared with other broad-basket commodity ETFs since inception through the end of August.

It may be that the excess return generated by this fund's strategy can't be harnessed in a cost-effective way. USCI's expense ratio is 0.95%, and the fund incurs additional costs from brokerage fees. Investors can expect to pay up to 1.17% a year, which makes USCI the most expensive commodity exchange-traded product in an already-expensive space. The fund's estimated holding cost, which takes additional fees and tracking error into account, is 1.32% a year. This high cost can quickly eat into any excess return.

USCI's middling return relative to its category isn't as important as its ability to act as a portfolio diversifier and inflation hedge. Few investors buy commodity exposure looking for market-beating returns. Because of their low correlation with equities and fixed-income assets, a long-term investment in a broad basket of commodities makes the most sense as portfolio diversification in most market environments. From 1970 to 2004, commodities were negatively correlated with other asset classes like global equities and domestic bonds. The correlation between commodities and the S&P 500 rose significantly after the financial crisis in 2008, but it appears to be declining again today. A 2006 study by Ibbotson Associates also showed that including commodities in portfolios improved their risk and return characteristics. During USCI's relatively short record, its correlations to both the S&P 500 and the U.S. bond market were lower than the category average's. If the fund can continue to provide above-average diversification, it might be an attractive choice despite its high price tag.

This fund also can be used as an inflation hedge. Commodities tend to be more correlated to inflation than any asset other than cash. Some of USCI's inflation protection comes from the interest earned on the T-bills it holds as collateral. As an inflation hedge, commodities usually underperform in periods of low inflation and outperform when inflation is high, allowing investors to maintain their purchasing power.

How the Portfolio Works
USCI's index, the SummerHaven Dynamic Commodity Index Total Return, reconstructs its holdings each month by using futures price signals to choose 14 commodities out of a pool of 27 options. This ETF uses futures contracts to provide commodity exposure. A futures contract is an agreement that requires the holder to purchase a certain quantity of a commodity from the issuer at a predetermined price for delivery on a specific date. Futures contracts, like other methods of buying commodity exposure (physical commodities or the stock of commodity-producing firms), are influenced by their own set of complications that prevents them from perfectly tracking spot prices. Roll yield, or the gain/loss incurred when a contract is sold in order to avoid delivery of the commodity, is the primary culprit. "Rolling" is the act of selling contracts close to expiration and buying contracts for the same commodity with a further-off expiration date. The difference in price between the two contracts can be positive (if the longer-dated contract is cheaper, known as backwardation) or negative (if the longer-dated contract is more expensive, known as contango). Contango has been a significant headwind for commodity markets during the past several years, particularly energy commodities: In 2012, an investor tracking front-month natural gas futures would have taken a significant loss even as the spot prices rose, solely because of contango.

USCI's underlying research showed that backwardation indicates low inventory of a commodity, and contango indicates high inventory. Commodity prices tend to be more volatile when inventory is low, and the study revealed that low-inventory commodities generate excess return from earning a risk premium for that volatility. To capitalize on this particular signal, the index determines whether each commodity is in backwardation or contango by calculating the percentage difference between the price of the front-month contract (the one closest to expiration) and the next-closest contract to expiration for each of the 27 possible commodities. The seven that exhibit the most backwardation or the least contango are chosen for inclusion that month.

Next, the seven commodities exhibiting the greatest futures price momentum are picked. The same research showed that commodities with high futures-price momentum significantly outperform low-momentum commodities. Momentum is calculated by taking the percentage difference between the front-month contract and the corresponding contract 12 months prior for the remaining 20 commodities. The seven commodities whose price has increased the most are chosen.

After the 14 constituents are selected, the futures contract that minimizes contango or maximizes backwardation is chosen for each commodity. Equal weighting is unusual for equity funds but has a long history as a commodity-indexing strategy.

The fund's sector weightings change every month, but between August 2010 and July 2013, energy averaged 25% of the portfolio, with grains (22%), softs (15%), industrial metals (15%), livestock (13%), and precious metals (10%) making up the rest. Allocations between commodity sectors vary widely from fund to fund--some, like iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG), overweight energy. GSG's current weighting to energy commodities is 73%. Others give more weight to agriculture and softs, like GreenHaven Continuous Commodity Index (NYSEARCA:GCC), which sports a consistent 58% weighting to the two sectors. Investors should always examine a broad commodity fund's sector weights.

Don't Forget Tax Considerations
For tax purposes, USCI must mark to market its futures contract holdings at the end of each year. Any gains made over the course of the year will be realized and passed through to investors. For investors in USCI, 60% of the gain will be taxed at the long-term capital gains rate and 40% at the short-term rate, whether or not the investor has actually sold the fund. Any futures-based commodity ETF will receive this tax treatment. Gains made by the industrial-metals-related contracts in the portfolio are exempt from this rule. USCI is a limited partnership, so the fund generates a K-1 form at tax season instead of the usual 1099. Investors who want to avoid the tax bite or filing complications should consider commodity exchange-traded notes, which provide the returns of a commodity index without actually holding futures contracts.

Other Options
PowerShares DB Commodity Index Tracking (NYSEARCA:DBC) is one of our top picks for commodity exposure. Its index uses an optimum-yield methodology that mitigates the negative impact of contango over time. Instead of simply tracking front-month futures, the index picks contracts with an expiration date of up to 13 months that will produce the least negative or most positive roll yield. DBC's optimal yield is realized after it sells its contracts, so it can take time for the fund to outperform competitors. DBC charges 0.85% and is expected to accrue up to 0.08% in brokerage fees every year. The fund's estimated holding cost is 1.13% a year. We took a closer look at this fund in April.

Although commodities ETNs avoid the tax treatment of similar ETFs, they expose investors to the credit risk of the issuer. ELEMENTS Rogers International Commodity Index ETN (NYSEARCA:RJI) is our favorite commodity ETN for its diverse holdings and stellar credit quality. It tracks almost 40 commodities weighted by worldwide consumption, and the note is backed by government agency Swedish Export Credit Corporation, which gives it the best credit quality of any ETN issuer. RJI costs a relatively low 0.75% a year and does not charge additional brokerage fees.

One of our favorite actively managed commodities funds is PIMCO Commodity Real Return Strategy (PCRAX), which carries a Morningstar Analyst Rating of Gold. This fund uses a basket of derivatives to track the Dow Jones-UBS Commodity Index. Because derivatives only require a small amount of collateral, the fund takes the remaining assets and invests in an actively managed portfolio of bonds. Although this fund's inflation-hedging qualities are enhanced by its large exposure to TIPS bonds, it also takes on more interest-rate risk. PCRAX costs 1.19%, and its institutional share class charges 0.74%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.