Which Is Better, A Commodity Mutual Fund or an ETP?

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Includes: ALT-OLD, DBC, DDP, DEE, DJP, DPU, DYY, GCC, GSC, GSG, GSP, LSC, RJI, UCD, UCI
by: Hard Assets Investor

by Brad Zigler

Commodities are the lifeblood of this site. And with all the ink—er, electrons—devoted to the analysis of exchange-traded products here, you'd think these newfangled notes and funds had sucked up most of the assets allocated to the commodity space.

You'd be wrong, though. Truth be told, most retail investors are getting their diversification dollop through mutual funds—and rather expensive ones at that.

As of July 23, broad-based commodity funds held more than $30 billion in assets. (This counts only those funds holding futures or futureslike derivatives, not ones holding so-called commodity stocks.) Investors have tucked $21.3 billion into five mutual funds and scattered another $8.9 billion among 15 exchange-traded products.

The asset-weighted average expense borne by investors in commodity mutual funds is 1.34 percent per annum versus the annual cost of holding exchange-traded products at 0.81 percent.

So how do mutual funds justify their higher cost? With better performance? More services? To find the answers, we have to make sure we're comparing apples with apples.

First of all, we have to separate the commodity mutual funds by their management style—passive (or index-tracking) and active.

"Passive" Mutual Fund

Ticker

Market

Cap

($mm)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

Pimco Comm Real Return

PCRAX

16,500

1.24

-8.19

17.56

-0.47

One mutual fund, the Pimco Commodity Real Return Strategy Fund, derives its commodity exposure by replicating, to one degree or another, the returns of an index. Well, in actuality, the managers of the PCRAX portfolio try to outdo the benchmark Dow Jones-UBS Commodity Total Return Index by actively trading the collateral, or the money market instruments that are used to secure the commodity derivatives. You wouldn't be far off the mark in saying only a part of the fund is passively managed.

With $16.5 billion under management, PCRAX is the 800-lb. gorilla of commodity funds. But for all that management, the fund lost 8.19 percent for the year through July 23. The fund also has one of the lowest volatility stats in the commodity fund universe. It's because of that relatively low volatility that the fund's Sharpe ratio is so negative; the fund is punished for not producing more positive returns with its low variance.

Active Mutual Funds

Ticker

Market

Cap ($mm)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

Rydex/SGI Managed Futures

RYMTX

2,300

1.99

-8.94

6.66

-1.36

Oppenheimer Comm Strat

QRAAX

1,500

1.23

-7.89

21.64

-0.37

Russell Comm Strategies

RCCSX

794

1.66

-2.50

12.50

-0.21

Rydex/SGI Long/Short Comm

RYLBX

172

1.84

-5.98

19.32

-0.32

Total

4,766

The other four commodity funds allow their managers free rein within each portfolio's mandate to pursue index-beating strategies. The big funds produced returns fairly close to mark set by the PCRAX portfolio this year. Like PCRAX, the Rydex/SGI Managed Futures portfolio (RYMTX) was penalized with a low Sharpe ratio for the deeply negative return earned with its low volatility.

The Russell Commodity Strategies Fund (RCCSX) was launched in July, so its figures actually represent less than one month of operation. The multistrategy funds' impressive asset build is a testament to the notion that brokered mutual funds are sold rather than bought.

The Oppenheimer Commodity Strategy Total Return Fund allocates its commodity-linked investments based on the weightings of the components in the fund's benchmark, the S&P/GSCI (formerly the Goldman Sachs Commodity Index), though its managers use active strategies within those allocations. The Rydex Long/Short Commodity Fund (RYLBX) pursues a more singular approach, attempting to exploit pricing disparities between related futures and other commodity derivatives. While its returns this year are negative, RYBLX takes "Best of Class" honors for the actively managed commodity mutual funds.

So that's what mutual funds have offered investors this year. What of the exchange-traded products (ETPs)? We'll need to do a lot more slicing and dicing of these apples to make direct comparisons.

First let's look at the passive long-only portfolios:

Passive Long Unleveraged ETFs

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

PowerShares DB Comm

DBC

4,301

2,105.8

0.85

-8.85

20.26

-0.44

iShares GSCI Comm

GSG

1,523

415.7

0.75

-8.71

23.76

-0.37

GreenHaven Cont Comm

GCC

243

85.0

0.85

-2.58

14.42

-0.19

Total

6,067

Among index-tracking exchange-traded funds, the GreenHaven Continuous Commodity Index (NYSEARCA:GCC) portfolio has produced the best year-to-date performance. Its equal-weighted benchmark—the former iteration of the Commodity Research Bureau (CRB) Index—gets the credit for its relative underweight in petroleum products and its comparative overweight in agricultural commodities.

The other two funds hit performance numbers not far from those produced by the mutual funds examined earlier.

But what of ETNs?

Passive Long Unleveraged ETNs

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

iPath DJ-UBS Comm

DJP

1,975

371.8

0.75

-7.48

17.58

-0.43

Elements Rogers Int'l

RJI

435

439.8

0.75

-6.12

19.78

-0.32

iPath GSCI TR

GSP

84

24.9

0.75

-8.99

24.36

-0.37

E-TRACS CMCI

UCI

80

8.2

0.65

-7.23

25.11

-0.29

GS Connect GSCI Enhanced

GSC

57

9.6

1.25

-7.48

23.67

-0.32

PowerShares DB Comm Long

DPU

5

4.3

0.75

-9.83

30.02

-0.33

Total

2,636

Exchange-traded funds are very much like their mutual fund cousins, in that they're portfolios of actual securities or derivatives. Exchange-traded notes, however, are zero-coupon debt instruments issued by financial institutions that promise to deliver a commodity index return—provided the issuer remains solvent. An investor thus trades away index tracking error and frictional transaction costs for credit risk by using ETNs.

For the most part, that trade-off paid off this year in slightly better returns, most especially from the Elements Rogers International Commodity ETN (NYSEARCA:RJI). That, in large part, is due to the global reach of its underlying index.

We should, as a matter of course, take a quick look at the leveraged products.

Passive Long Leveraged (2x) ETF

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

ProShares Ultra DJ-UBS Comm

UCD

12

16.7

0.95

-16.11

33.83

-0.48

Passive Long Leveraged (2x) ETN

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

PowerShares DB Comm Dbl Long

DYY

13

45.4

0.75

-16.87

41.87

-0.41

The leveraged instruments produced losses approximately double those of their unlevered siblings. Their relatively small market capitalizations attest to their use as tactical tools—temporary hedges or cash management stratagems.

The beauty of the futures market is the ease with which one can take a short position. It costs no more to margin a short position in futures than a long position. That opens the door to wider trading opportunities. This year, short commodity ETNs (to date, there are no short-only ETFs in the U.S. market) were successful in exploiting that opportunity.

Passive Short Unleveraged ETN

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s)

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

PowerShares DB Comm Short

DDP

3

4.7

0.75

5.36

25.21

0.21

As you can see, unlevered short ETNs aren't very popular. The reason? These instruments are used tactically, not as long-term holds. The capitalization of the double-short note is four times that of the singleton, though still small. Largely that's because investors use the ETN as a proxy for futures in hedging strategies. Hedges are more efficient if they're leveraged—a little capital that goes a long (short?) way to garner index exposure.

Passive Short Leveraged (2x) ETN

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

Power Shares DB Comm Dbl Short

DEE

12

7.2

0.75

6.38

41.87

0.15

So that's the menu of passive exchange-traded instruments. If you look at the asset-weighted returns for the long-only unlevered exchange-traded products, you'll see that there's hardly any daylight between them and the "passive" commodity mutual fund. PCRAX, remember, lost 8.19 percent this year. The exchange-traded products collectively lost 8.18 percent.

What about the actively traded portfolios? To what can we properly compare them? Well, while there aren't yet truly active exchange-traded fund portfolios, there are a couple of products that follow mechanistic indexlike strategies incorporating long and short position turnover.

"Active" Long/Short ETF

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

iShares Divers Alt Trust

ALT-OLD

70

22.3

0.95

0.22

4.47

0.02

"Active" Long/Short ETN

Ticker

Market

Cap

($mm)

Daily

Volume

(1,000s

Annual

Expense

(%)

YTD

(%)

Volatility

(%)

Sharpe

Ratio

Elements S&P Comm Trend

LSC

67

83.3

0.75

-18.59

14.09

-1.33

Obviously, there's been mixed results with these strategy-following products. In fact, the Elements S&P CTI ETN produced the worst year-to-date performance in our universe. The note tracks Standard & Poor's Commodity Trends Indicator Index, essentially a long/short strategy design to capture roll yields. But big contangos were obviously hard to overcome this year.

The iShares Diversified Alternatives Trust is actually an absolute return strategy that uses long and short positions in futures and forwards with historically low correlation to traditional asset classes.

The asset-weighted return for the active ETPs is -8.98 percent. The active commodity mutual funds extant since the beginning of the year earned a -8.42 percent return. More daylight here, but just over 50 basis points.

The Bottom Line

Judged only on share price appreciation—diminution, actually—only actively managed mutual funds outperformed their ETP analogs. The returns earned by passive ETPs and mutual funds were nearly identical.

Does that mean active commodity mutual funds earned their high fees? Not necessarily. The performance difference wasn't that great. And we haven't examined the other factors an investor must consider when making a choice between a mutual fund and an ETP. Will there be sales charges imposed on the mutual fund transaction? What about commissions and spreads on the ETP trade? Is there an opportunity cost for an end-of-day mutual fund purchase or redemption? What about the counterparty risk inherent in an ETN transaction?

The bottom line is this: There's little real difference between the performance of mutual funds and ETPs in the commodity space, but a whole lot of difference in the products' risk characteristics. If investors can concentrate on tallying up the comparative costs and benefits of those, they'll be better able to judge the products' utility.