A good idea

For investors in commodities..
Just One ETF: A New Approach to the Roll Problem in Commodities ETF Investing
Douglas Wolfe

Douglas Wolfe heads portfolio management and trading operations at Saddle River Capital Management. Previously, he spent 10 years as an equities trader at Salomon Smith Barney.

Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

The asset class we are most bullish about for the upcoming year is commodities. Specifically, the United States Commodity Index Fund (USCI). The reason we choose commodities is twofold: We feel it is one of the most underutilized sectors in a well-diversified portfolio, coupled with the fact that if/when inflation begins moving higher and/or economies begin to expand – especially the emerging-market economies – the commodities sector will be the direct beneficiary.

USCI is a fairly new ETF, managed by SummerHaven Index Management. SummerHaven’s co-founder and director of research, Geert Rouwenhorst, is a Yale University professor. Rouwenhorst is best known for a paper he co-authored earlier this decade with Gary Gorton, “Facts and Fantasies about Commodity Futures.”

The fund is based on the research that shows expected returns are higher if you concentrate a commodity portfolio in the backwardated portion.

In commodity trading practice, backwardation is a condition in futures markets when contracts with nearer expiration dates are more expensive than those with further-out expiration dates. Contango is the opposite, with futures with further-out expiration dates costing more than those with nearer expiration dates.

Contango can erode fund returns because managers have to pay up when they “roll” positions from expiring contracts to later-month ones to maintain exposure. That situation is reversed when markets are in backwardation, because expiring positions are rolled into contracts that are less expensive than the contracts that are expiring.

USCI began trading in early August. What makes USCI very intriguing as opposed to the other commodity ETFs out there is its investment approach. USCI is composed of 14 futures contracts that are selected on a monthly basis from a list of 27 possible futures contracts.

The SummerHaven Dynamic Commodity Index reflects commodities from six commodity sectors: energy (e.g., crude oil, natural gas, heating oil, etc.), precious metals (e.g., gold, silver, platinum), industrial metals (e.g. zinc, nickel, aluminum, copper, etc.), grains (e.g., wheat, corn, soybeans, etc.), softs (e.g., sugar, cotton, coffee, cocoa), and livestock (e.g., live cattle, lean hogs, feeder cattle).

Each month, the index picks 14 commodities: The first seven selections are made using the most backwardated commodities, and the other seven are selected based on the greatest 12-month price increase, weighting the selected commodities equally in the portfolio. The index is rebalanced monthly.

So because of the seven inclusions that are based on momentum, there could be contangoed commodities held; doesn’t that go against the theory at the basis of the index – to prevent the buying high, selling low that rolling would entail?

There could be contangoed securities that are selected for the seven spots based on price momentum. Whether these securities are backwardated or in contango doesn’t take away from the fact that they are the best-performing securities over the 12 month period. The way I see it – and I will put it into my own words – I would rather invest in a security that is going to give me the best price performance than the one that looks the prettiest.

How does this ETF fit into your overall investment approach? Tell us a bit about your strategy and goals.

My firm, Saddle River Capital Management, manages five ETF portfolios. These portfolios are based on risk, and range from an Aggressive Growth portfolio to an Income and Preservation portfolio. We have been managing these portfolios for seven years.

We have found that an allocation to commodities is a very underutilized asset class in most investors portfolios. Commodities have a historically low correlation to equities and provides a very good hedge against inflation.

Tell us a little more about commodities. What makes this area your top pick?

For the purposes of this article we are speaking of commodity futures. We are not speaking of the companies that make their business in the production of these commodities – although these ETFs will also benefit from the appreciation in price of the underlying commodities.

We believe although not a concern at present, inflation could pose a concern in the future. If inflation does begin to move higher, commodity ETFs will give the investor a nice hedge to rising rates. We also believe that as economies continue to recover, especially the emerging markets, commodities in the form of hard assets will continue to be in demand.

Does your view differ from the consensus sentiment in this area?

The characteristic that intrigues us the most about USCI is the fact that the portfolio rebalances every month. USCI is also looking at a possible 27 commodities. The other commodity ETFs that cover this space have fixed portfolios. The investor is stuck with that portfolio and those weightings.

Any given commodity can be out of favor for months, maybe longer. With USCI, the portfolio is constantly rotating giving you exposure not only to a more diverse set of investments. but a group of investments that are in favor currently.

It’s been outperforming DBC and DJP in its short history, but also in backward-looking measures; is that likely attributable so far to its tendency to hold lower-inventory commodities?

The outperformance to the above mentioned securities could be explained by a number of factors. One thing I will mention is the research that Rouwenhorst was involved with and his subsequent paper made a case for active investing and the philosophy that inventories are a fundamental driver of risk premiums:

  1. Low inventories tend to cause an increase in expected future spot price volatility.

  2. Long investors should expect to earn more to accept this greater price risk.

  3. Inventories cannot be easily replenished; therefore higher inventories have a tendency to persist.

  4. Low inventory levels are signaled by price-based measures.

What catalysts, near-term or long-term, could move this class significantly?

As mentioned, increasing inflation, the continued growth in areas such as emerging markets, and even supply and demand issues, like we have just seen with the Russian wheat crop, can all play a significant role in the continued success of this asset class.

What could go wrong with your pick?

A downturn in the economy which will lead to less demand across the world for commodities would play a big part in why the commodity space would be unsuccessful. While commodities are generally not correlated to the equities market, we saw how all asset classes acted in 2008. While the markets were dropping, all asset classes were highly correlated. Unfortunately, in times like that, there is no safe haven but cash.