USCI – The Commodity ETF Evolves
The United States Commodity Index Fund (USCI) began trading last Tuesday (8/10/10). The fund’s objective is to match the SummerHaven Dynamic Commodity Index Total Return, less expenses. The underlying index is comprised of 14 futures contracts, selected on a monthly basis from a universe of 27. Composition of the rules-based index in any given month will be determined quantitatively.
Contrary to what you might have read, USCI is not an actively-managed ETF. The fund’s composition is not determined by manager discretion. Instead, the holdings are determined by an index and remain static between monthly rebalancings. The prospectus (pdf) elaborates on the fact that no human bias is introduced into the process. Even its name clearly identifies this product as an “index” fund.
That said, the index is dynamic and its composition can change significantly from month to month. Quantitative dynamic indexes are nothing new. PowerShares pioneered their use in the ETF space, launching more than 40 funds using this concept beginning with the introduction of PowerShares Dynamic Market (PWC) in 2003. However, I believe USCI is the first time the concept has been used with a pure commodity ETF.
The underlying index was developed by SummerHaven Index Management LLC and is based upon academic research by Yale University professors Gary B. Gorton and K. Geert Rouwenhorst, and Hitotsubashi University professor Fumio Hayashi. Much of the research behind the fund is documented in the 2004 paper titled “Facts and Fantasies About Commodity Futures.” The methodology employed by the index seeks to minimize the harmful effects of contango (negative roll-yield) by favoring commodities in backwardation (positive roll-yield) and longer term contracts.
Each month 14 of the 27 eligible commodities are selected to be index components, with a minimum of one commodity from each sector (energy, grains, industrial metals, livestock, precious metals, and softs) to ensure diversification. The monthly commodity selection is a two-step process:
- The seven commodities with the highest percentage price difference between the closest-to-expiration futures contract and the next closest-to-expiration futures are selected (the seven displaying the most backwardation).
- From the remaining 20 eligible commodities, the seven with the highest one-year percentage price change are selected (the seven displaying the most one-year momentum). If all six sectors are not represented by at least one commodity, then a substitution process is employed until the constraint is satisfied.
The 14 selected commodities are included in the index for the next month on an equally-weighted basis. Due to the dynamic monthly commodity selection, the sector weights may vary from approximately 7% to 43% over time.
Selections are made on the fifth business day before the end of the calendar month. The rebalancing then occurs during the last four days of the month, with one-fourth of the required rebalancing taking place each day.
For the month of August 2010, the fund’s sector allocation and component futures contracts are:
- Energy (14.3%): Crude Oil (WTI) SEP11, Natural Gas OCT10
- Grains (14.3%): Soybean NOV10, Soybean Meal OCT10
- Industrial Metals (21.4%): Copper OCT10, Nickel MAR11, Tin DEC10
- Livestock (7.1%): Lean Hogs DEC10
- Precious Metals (21.4%): Gold OCT10, Platinum OCT10, Silver DEC10
- Softs (21.4%): Cotton DEC10, Coffee DEC10, Sugar #11 OCT10
USCI is the latest evolution of commodity investing products for retail investors. Phase 1 kicked-off 54 years ago with the introduction of Van Eck International Investors Gold (INIVX) in 1956. It is currently the oldest mutual fund still in existence targeting commodity producer equities. A plethora of similar funds arrived in the 1980s.
Phase 2 was the introduction of commodity producer ETFs, the first being SPDR Select Sector Materials (XLB) 1998. Phase 3 is marked by the arrival of the first physically-backed commodity ETF, SPDR Gold Trust (GLD), in 2004. Physically-backed products have been extremely successful with retail investors, but are thought to be impractical for anything except precious metals.
Phase 4 began in 2006 with PowerShares DB Commodity Index (DBC), the first ETF based on commodity futures. Retail investors, impressed with the ability of physically backed ETFs to track spot prices, were not fully prepared for ETFs implemented with futures contracts. The past four years have been a period of prolonged contango conditions in the commodity markets. As such, futures indexes have greatly underperformed spot indexes, leaving many retail investors perturbed.
Now we begin Phase 5, which is marked by ETF sponsors employing dynamic indexing techniques to combat the negative effects of contango, capture the positive effects of backwardation, and maximize total return. USCI is likely to be just the first of many such Phase 5 products as the evolution of commodity investing continues.
Disclosure covering writer, editor, and publisher: Long GLD. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.