By
Morningstar
:
By Abby Woodham
Investors interested in the broad commodity market are faced
with a wide range of choices. The two main differentiators between
funds are the weighting of each commodity, and whether they
implement a methodology that protects the fund from potential
negative effects of rolling futures contracts. Understanding these
differences is the key to picking the right fund for your
investment needs, as funds with slightly different methodologies
can have dramatically different returns. Today we'll profile one of
our favorites in this broad-basket space:
GreenHaven Continuous Commodity Index ETF (
GCC
)
, which offers an unusual and successful methodology.
GCC employs a unique strategy that allocates equally to 17
commodities. This may seem strange when compared with broad equity
indexes, which usually weight by market cap. However,
equal-weighting is a commodity indexing strategy with a long
history; many important academic papers studying the returns of
commodities as an asset class have tracked an equally weighted
index. Commodity futures are a zero-sum game, meaning that every
long position is offset by a short position. As a result,
commodities have no market capitalization to weight by, and every
index must pick a distinct strategy to follow. Most broad
commodities funds weight their portfolios by economic significance,
a proxy for market cap, which results in an energy allocation that
can go as high as 70%. When investors buy these energy-heavy funds,
the returns of agriculture and metal commodities are diluted with a
small relative weighting. Not so with GCC, which is more than 80%
nonenergy commodities like corn, sugar, and platinum.
Investing in commodities is not for everyone. GCC is most
appropriate for two kinds of investors: those who believe global
demand for commodities will grow in coming years, and those seeking
diversification and an inflation hedge. Both types should
understand that commodities are a high-volatility asset class. The
former should keep an eye on demand from China and India, and the
latter should manage their expectations.
Here's why: historically, commodities have had low correlation
with stocks and bonds, but that relationship has been tested in
recent years. Investors should be aware that correlation to
equities has been on the rise since the financial crisis. If stocks
starts to decline, commodities are unlikely to keep a portfolio
afloat because there is now an almost 80% correlation between the
S&P 500 and the broad commodity index. Because investing in
commodities has been effectively democratized through ETFs like
GCC, it is unlikely that correlations will drop very far in the
future. As an inflation hedge, commodities have usually
underperformed during periods of low inflation, and outperformed
during inflationary environments. Generally, commodities shine at
the beginning of a recession and the end of an expansion.
Instead of owning huge warehouses full of corn and oil, GCC
invests in commodities futures. These are contracts that require
the holder to purchase a certain quantity of a commodity, at a
predetermined price, delivered on a specific date. When a futures
contract expires, the physical delivery of the product occurs. To
prevent taking these deliveries, GCC "rolls," which means selling
the currently owned, close-to-expiration contract, and buying a
contract of the same commodity that expires further in the
future.
Rolling can produce two effects, called contango and
backwardation. If the longer-term contract is priced higher than
the expiring one, this is called contango and results in a negative
return every time futures contracts are rolled. If the opposite
occurs and the longer-term contract is priced cheaper, this is
called backwardation and the fund makes money rolling contracts.
The commodities market has been stuck in persistent contango for
the last few years.
- source: Morningstar Analysts
Because contango can eat up returns for a fund, GCC spreads out
its contracts across the futures curve instead of just purchasing
the front-month contracts. Each commodity is purchased through
contracts spread across two to five of the next six delivery
months. Some funds, such as large competitor iPath DJ-UBS Commodity
Index ETN (
DJP
), have no protection from contango. We prefer funds tracking
indexes that pick and choose contracts to minimize contango.
Potential investors in GCC will have an investment thesis that
rests upon a very positive outlook for future commodity demand.
Economic and population growth in the emerging markets will
continue to place greater strain on ultimately limited supplies of
the world's natural resources. The U.N. projects an 11% global
population increase by 2020 and a 20% increase by 2030. At the same
time, the global middle class' surging growth will compound demand
for food and energy as diets and transportation habits become more
like the West's.
The largest threat to this story is a major slowdown within the
emerging markets, namely China. The nation is a chief demand-side
driver of virtually all commodities. The communist nation has
staked its legitimacy on sustained 8% GDP growth and has engaged in
a tremendous infrastructure binge to keep up the pace. If that pace
slows and the "Chinese bubble" pops, the lightened commodity demand
could provide substantial headwinds for GCCs commodity futures
holdings.
Portfolio Construction
GCC tracks the Thomson Reuters Equal Weight Continuous Commodity
Total Return Index, which provides the return of 17 different
equally weighted commodities, plus the interest on Treasury bills
serving as collateral. Metals, "soft" commodities (coffee, sugar),
and agriculture make up about one fourth of the portfolio each.
Energy comprises only about 18% of the fund, which is the lowest by
far of its peers. The fund is rebalanced at the end of every day,
which incurs brokerage fees. These fees are added on to the
published expense ratio, so prepare to pay extra.
GCC is structured as a limited partnership, which means that
investors will receive a K-1 form instead of a 1099 during tax
season. Each year, GCC must mark to market its contracts, which in
the eyes of the IRS is equivalent to selling them. Any gains made
over the course of the year will be realized and passed through to
investors. Each year, 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.
Fees
GCC charges 0.85% every year, but also costs an additional 0.20% a
year for brokerage fees. At 1.05% the fund is more expensive than
its peers. Cost is a real drawback for GCC.
Alternatives
PowerShares DB Commodity Index Tracking (
DBC
) tries to mitigate the negative impact of rolling. Instead of
tracking front month futures, when it comes time to roll a contract
the fund picks the one that will produce the most positive roll
yield, up to 13 months off from the present date. DBC doesn't avoid
the 60/40 tax rule that broad-basket commodity ETF investors must
pay.
The most vanilla broad-basket commodities product available is
iPath DJ-UBS Commodity Index TR ETN (
DJP
). It tracks front-month futures, which are the ones most closely
linked to the actual spot price of each commodity. Its
path-dependent fees mean investors can be charged extra. DJP has
not outshone its competitors, likely because the fund is
unprotected from contango.
Because iShares S&P GSCI Commodity-Indexed Trust (
GSG
) is weighted by economic significance, it is heavy with energy:
almost 70% is energy commodities. This has resulted in higher
volatility than its peers. GSG avoids the 60/40 rule by buying
contracts linked to the return of 24 commodities, instead of buying
the futures itself.
The newest offering is United States Commodity Index (
USCI
), which has the most complicated methodology. Each month, 14
commodities are chosen out of a pool of 27 options. Using a set of
rules, seven are chosen that minimize contango/maximize
backwardation in the coming month, and seven are picked that do the
same on a year-over-year basis. USCI is young, but it has performed
well since inception and has experienced low volatility.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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