In my last article, I wrote a few words about smart beta bond ETFs. This type of ETF could be an interesting choice for more experienced investors, although I don’t think that they are always the best solution for inexperienced investors. However, what about smart beta commodity ETFs?
If smart beta bond ETFs are currently only a “small part” of the whole smart beta ETF universe, smart beta commodity ETFs are only a “micro part.” But they exist for sure, and some investors are looking for them, simply because they want to have a smarter solution than what basic indices can provide. So are smart beta commodity ETFs worth your attention? (Some commodity ETFs are actually ETNs – a different product; there is some credit risk, etc. However, that’s not the point of this article, and so I use the word "ETF" in the title etc. for simplicity.)
Factors that are used in smart beta commodity ETFs are not always the same as that which are used in smart beta equity or bond ETFs. However, we can say that there are three basic types of factors that are mostly used. Some smart beta ETFs are focused on the volatility factor (simply choosing commodities with the lowest volatility). You could also find smart commodity ETFs that are based on momentum strategy (choosing those commodities which grew the most during the previous period, mainly 12 months). The third factor that you can see mostly in smart beta commodity ETFs is the “carry” factor. This factor is focused on two situations called contango and backwardation. We can say that carry and momentum factors are most common and that they are also sometimes used together.
So, let’s compare two commodity ETFs that can be seen as smart beta ETFs with two “normal” commodity ETFs.
Two smart commodity ETFs...
Probably the best two representatives of smart beta commodity ETFs are the PowerShares DB Commodity Index Tracking Fund and the even “smarter” United States Commodity Index Fund.
The United States Commodity Index Fund (USCI), tracking SummerHaven Dynamic Commodity Index Total Return, is likely the most actively managed smart commodity ETF in the market. SummerHaven Dynamic Commodity Index is rebalanced on a monthly basis and consists of 14 equal weight commodities (out of 27 possible futures contracts). So every month, 14 commodity futures are chosen, based on market price signals – backwardation and 12-month price change.
The first half (7 commodities) of the portfolio is chosen based on backwardation or contango – the carry factor mentioned earlier. The idea is simple. Managers look for 7 commodities with the greatest backwardation or least contango, if there are only a few commodities with backwardation. Why is this important? Well, contango is a common situation, for instance, because under normal circumstances investors are willing to pay a premium to avoid the inconvenience and costs associated with transporting, storing or insuring commodities. And it is also a fact that, if you hold commodities futures for a long period, you must perform a regular “roll process” (rolling futures), in which contracts nearing expiration are sold, and longer-dated contracts are purchased. The problem is that if the market is in contango, the next contract does not cost the same as the current one; the next contract is more expensive, so that the rolling process may also be expensive in this situation. That’s why long-term investors try to avoid contango and the reason why USCI uses this strategy.
The second half of the portfolio (i.e. 7 out of 20 commodities that are left after the first step) is chosen based on the 12-month price change, which means nothing other than the momentum strategy mentioned at the beginning. To clarify, in this case, “momentum is measured as the % price difference between the futures price for the closest-to-expiration contract and the price of the closest-to-expiration contract 12 months ago for each commodity”. The whole idea of this common strategy is to capitalize on the continuance of existing trends in the market, so you are long in an asset (in this case, future contract) that has shown an upward trending price. As you can expect, because of this active approach, the TER is high – 1.11 %. The AUM is about $500 million, so enough.
OK. Let’s compare USCI with the PowerShares DB Commodity Index Tracking Fund (DBC), because there are certainly some similarities. First of all, DBC is much bigger; the AUM is about $2.3 billion. Also, the TER is lower, “only” 0.89 %. DBC seeks to track the DBIQ Optimum Yield Diversified Commodity Index Excess Return. The similarity to USCI is that there are also 14 commodities in the DBC portfolio (index). However, DBC is much less actively managed, because the portfolio (index) is rebalanced only once a year in November. This is a big difference, although the similarity is that DBC (index) also uses the smart beta strategy to choose the right commodities, at least according to PowerShares. The strategy that DBC uses is to “address the impact rolling futures can have on commodity returns”. So, once again, they are trying to minimize contango, or in other words, they are also focusing on the carry factor. Except that DBC also uses different weighting from “normal” commodities indices (S&P GSCI Commodity Index…), which means that there is a cap on energy commodities. (Unfortunately) the cap is not very low; the weight of energy is now still about 55 % – too much.
... And two normal commodity ETFs
I have already mentioned the S&P GSCI Commodity Index, so it would be only logical to add iShares S&P GSCI Commodity-Indexed Trust (GSG) to our comparison as representative of “normal” commodity ETFs. We could say that the S&P GSCI Commodity Index is the basic commodity index, with a long history and tradition. This Index was originally developed by Goldman Sachs in 1991 and currently consists of 24 commodities. So you can already see the difference between this Index and the aforementioned indices at first glance. I assume that everybody knows this Index, so I only mention that the current weight of the energy sector is about 62 %. The TER of GSG is 0.75 %. AUM is about $1.3 billion.
The last commodity ETF that I am going to mention in our comparison is iPath Bloomberg Commodity Index Total Return ETN (DJP). Yes, this one is ETN, so DJP do not invest in futures contracts or commodities themselves, because it’s more like a bond - there is some credit risk. However, leave that aside for now. This ETN is tracking the Bloomberg Commodity Index. This Index is not as old (was originally launched in 1998) nor as famous as the S&P GSCI Commodity Index, but people from Bloomberg say that this is an advantage. Why? Well, as I have already stated, the S&P GSCI Commodity Index is too overweight in the energy sector, and the Bloomberg Commodity Index is trying to solve this. With a few simple rules – no one commodity can represent more than 15 % (or less than 2 %) of the Index, and, more importantly, no sector can represent more than 33 % of the Index. You should also know that commodities within the Bloomberg Commodity Index are weighted 2/3 by trading volume and 1/3 by world production, with additional criteria of global economic significance. There are currently 22 commodities (rebalanced once a year) in the Bloomberg Commodity Index, and even with that different weighting, we can say that this is rather a “normal” index, not a smart beta one. The target weight of the energy sector for 2017 is 30.6 %, and for 2018 it is 30.43 %, the lowest in the 17-year history. The TER of DJP is 0.7 %, and AUM is about $800 million (that’s why I chose this one). So which ETF is the best?
Which one is the best?
First of all, recent years have been tough for commodities – that’s a fact, and even the “smartest” ETFs could scarcely change it. Either way, as you can see from the charts, the answer to our question of which ETF is the best is not easy. In the long-term period, USCI is clearly the winner with the highest return (lowest lost) and lowest volatility. But as you can see from Chart 3, in the last 12 months, USCI was actually the worst when speaking about the return. So, is this ETF really the best?
Chart 1: 5y Total return and volatility of chosen ETFs; source: ETFreplay.com
Chart 2: 3y Total return and volatility of chosen ETFs; source: ETFreplay.com
Chart 3: 1y Total return and volatility of chosen ETFs; source: ETFreplay.com
To be honest, I don’t think so. The whole outperformance in the long-term period is basically because of 1 or 2 years of lower losses between 2014 and 2016. Was this because of the strategy or was this simply coincidence? It is hard to say. In my opinion, this ETF is just too actively managed, and it is really difficult to predict how it will perform in the future. Therefore, I would probably not recommend USCI to the average investor who just wants a few commodities in the portfolio. Nevertheless, of course if you want to have an actively managed ETF, then yes, you could try this one.
In my opinion, GSG is also not the solution because, although the S&P GSCI Commodity Index is the well-known index, the weight of energy is too high.
DBC could be the choice for investors who are seeking a “smart” solution – but not as actively managed as USCI. The results so far are nice, and so this ETF is certainly worthy of your attention. However, in my view, there might be an even better solution.
Yes, DJP has not had the best results, but also never the worst. The idea of the Bloomberg Commodity Index is logical – it is basically a “normal” index with a cap on sectors. This could be important for investors who want to have commodities as a diversification part of a portfolio. In this case, you don’t want to have 60 % of such a part in one sector.
So the Bloomberg Commodity Index could be the solution, but I am not saying that DJP must therefore be the choice. I have used this ETF mostly because of the long history and high AUM. However, for instance, a few months ago, ETFs Bloomberg All Commodity Strategy K-1 Free ETF (BCI) was launched. Technically, BCI is not an index-tracking exchange-traded fund, and so BCI does not have to invest in all the components of the underlying Index. However, according to the factsheet, BCI will generally seek to "hold similar interests to those commodities included in the Bloomberg Commodity Index and will seek exposure to many of the commodities included in the Index under the same futures rolling schedule as the Index". This all with TER only 0.29 %.
Something like this could be the solution. Well, once again, it is not necessarily this specific ETF. However, in my opinion, the best way of choosing the correct commodity ETF for the average long-term investor could be to look for the ETF with the low(est) TER. However, naturally with sufficient AUM, because of liquidity. I would also personally prefer ETFs tracking the Bloomberg Commodity Index, because I think that this Index is better than the S&P GSCI Commodity Index, if for nothing else, for its diversification. Either way, the final decision is always up to you.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.