The Case For Commodities ETNs

In the midst of our Inside Commodities conference, Iâve been thinking about the various commodities funds out there, and was surprised at the distribution of assets among them. I know a lot of people are hesitant to put their money in ETNsâcredit risk sounds scary. But there are some very real advantages to ETNs, such as perfect tracking, that can make them well worth the risk.

To make my point, we need to start with an ETF:the iShares S'P GSCI Commodity-Indexed ETF (NYSEArca:GSG). As its name suggests, it seeks to track the S'P GSCI Total Return Index. It doesnât pull that off very well, as the graph below shows. In fact, GSGâs returns often differ from the GSCIâs by 1 percent or more!

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In comparison, the iPath S'P GSCI Total Return Index ETN (NYSEArca:GSP) tracks the same S'P GSCI Total Return Index perfectlyâand at the same 0.75 percent price as GSG.

This perfect tracking resulted in GSP outperforming GSG by over 1 percent over the past year. At its most extreme point, in April of this year, GSP was beating GSG by 3 percent!

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As I said, both funds have the same 0.75 percent expense ratio, so in a perfect world, both should be lagging their index by 0.75 percent. Instead, GSG lags by a significant amount beyond its expense ratio.

So whatâs up with the discrepancy between the two funds?

GSG, the ETF, has only one real holding in addition to its collateralâa GSCI Excess Return March 2014 futures contract. Note that thereâs a difference between the ETFâs âexcessâ return and the indexâs âtotalâ return.

Excess return only measures the returns above those which would be earned by cash collateral, while total return includes everything. In theory, GSGâs management of its collateral should work to equate the two indexes. But lately it hasnât.

The baffling thing to me is that GSG currently has $1.3 billion invested in it, while the almost-identical-but-better GSP only has $99 million. Maybe itâs the credit-risk factor thatâs holding GSP back, but if you can handle it, GSP is the better choice.

Whether your commodities index of choice is the GSCI is another whole story. But if it is your choice, at least make sure that you choose a product that tracks its index.

Don't forget to check IndexUniverse.com's ETF Data section.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.