New research from London-based exchange-traded fund issuer Source highlights the benefits of commodity ETFs that incorporate a dynamic trading strategy to manage exposure across the futures curve compared to those that are restricted to trading front-month contracts, where the futures curve is typically the steepest. According to the research, ETFs linked to so-called “second generation” indices, which deploy roll-optimised futures trading approaches, have delivered superior risk-adjusted returns compared to their “first generation” counterparts.

Chris Mellor, Executive Director, Equities Product Management, at Source.

Instead of investing directly in a physical asset, most commodity ETFs typically gain their required exposure through the use of futures contracts. Futures contracts are agreements between participants to buy or sell a particular commodity or financial instrument at a predetermined price and date in the future. By utilising futures to obtain exposure to a commodity, investors are able to avoid the storage and transportation costs associated with direct physical investment in the commodity.

The owner of a “long” position in a futures contract has effectively agreed to buy the underlying asset at a predetermined price and date, and may profit from an increase in the price of the underlying commodity. Conversely, the owner of a “short” position in a futures contract has effectively agreed to sell the underlying asset at a predetermined price and date, and may profit from a decrease in the price of the underlying commodity.

An investor incurs rolling costs due to the finite lives of futures contracts, requiring perpetual investments such as ETFs to settle expiring contracts and re-invest the proceeds into longer-dated futures contracts. Investors should be aware that the impact of rolling costs on portfolio value not only depends on the frequency of rolling but also on the shape of the futures curve. If each subsequent month on the futures curve is priced higher than preceding months, the commodity is said to be in contango. In contrast, if subsequent months are priced lower than preceding months, this situation is referred to as backwardation.

During contango an ETF with a monthly rolling schedule will find the forward month futures contracts cost more than the current month, thereby reducing the number of contracts it could purchase. The compounding nature of this effect may result in significant losses to the investor over time. Conversely, during backwardation the forward month futures contracts trades at a discount to the current month, meaning the ETF is able to buy a greater number of contracts at each rolling period. Over time, this may represent a significant gain to the investor.

First-generation indices, which are restricted to trading the front-month contracts where the futures curve is typically the steepest, are susceptible to significant rolling costs over time. Second-generation indices, however, typically use a range of tactics to manage the roll process more efficiently, including selecting different contract months or changing the timing of reinvestments, all of which may improve the trading performance. In a sense, second-generation indices could be viewed as a type of smart beta for commodities.

Source analysed the Sharpe ratios (the average return earned in excess of the risk-free rate per unit of risk) for several first-generation and second-generation commodity indices over the period between January 2001 and May 2016.

The results showed that the highest risk-adjusted returns of any commodity index over the last 15 years were achieved by two second generation indices – the Legal & General Investment Management Commodity Composite Index (LGIM) and the Deutsche Bank Liquid Commodities Indices Optimum Yield Index (DBLCI-OY), which delivered Sharpe ratios of 1.35. Other widely followed second-generation indices include the UBS Constant Maturity Commodity Index (UBS CMCI) and the Bloomberg Commodity Index 3M (BCOM 3M), which recorded Sharpe ratios of 1.28 and 1.17 respectively over the same period.

First-generation commodity indices, which do not apply the same strategic flexibility, had significantly lower Sharpe ratios, e.g. S&P Goldman Sachs Commodity Index (GSCI) at 0.46, Rogers at 0.43, Thomson Reuters/Commodity Research Bureau CoreCommodity Index (RJ/CRB) at 0.26, and Bloomberg Commodity Index (BCOM) at -0.06.

Dr Chris Mellor, Executive Director, Equities Product Management, at Source, commented: “The best way to diversify commodity exposure is through a strategy that offers diversity in commodity weighting, trading strategy and investment counterparties.

“Second-generation commodity indices generally offer better returns with a lower volatility than first-generation indices but a diversified combination of indices such as that in the LGIM Commodity Composite Index offers better risk-adjusted performance than any individual commodity index. Such ETFs are the closest thing to ‘smart beta’ in the commodities arena.

“Investors can use multiple investments in individual commodity trackers to diversify their commodity exposure and this also allows them to tailor their exposure to their own views. However, investing in a broad commodity fund is typically cheaper and definitely less effort to manage. Investors can go a step further than this and diversify their exposures across broad commodity indices as each has a different approach and performs differently across the market cycle.”

Investors looking to invest in a second-generation commodity ETFs are well catered for, with various funds listed on the London Stock Exchange. These include:

• Source LGIM Commodity Composite UCITS ETF (LSE: LGCU), which tracks the LGIM Commodity Composite Index and has assets under management (AUM) of $330m. It has a total expense ratio (TER) of 0.77%.
• db x-trackers DBLCI – OY Balanced UCITS ETF (LSE: XBCU), which tracks the DBLCI-OY Balanced TR Index and has AUM of $376m. TER 0.55%.
• UBS ETF (IE) CMCI Composite SF UCITS ETF (LSE: UC14), which tracks the UBS Bloomberg Constant Maturity Commodity Index and has AUM of $640m. TER 0.45%.
• ETFS Longer Dated All Commodities GO UCITS ETF (LSE: COMF), which tracks the Bloomberg Commodity 3 Month Forward Index and has AUM of $530m. TER 0.30%.
• WisdomTree Enhanced Commodity UCITS ETF (LSE: WCOG), which tracks the WisdomTree Optimised Roll Commodity TR Index and has $12m in AUM. TER 0.35%.