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Plugging Contango

By Benjamin Shepherd on April 27, 2011

As I’ve written many times before, commodities-focused exchange traded products (ETP) are the best vehicles for investors to tap into the materials bull run. By purchasing a single product, investors can build exposure to the entire commodities complex, or target specific commodity families such as metals or grains, or even just a single commodity. Exchange-traded products also don’t charge the high commissions that an investor incurs by playing the commodities markets with futures positions.

But “contango”–in which the futures price exceeds the future spot price–poses a challenge for ETPs that use futures positions to build their portfolios. Consequently, issuers are taking steps to limit the effects of contango in their products.

Barclays Bank (NYSE: BCS) rolled out 18 new commodity-focused exchange-traded notes (ETN) last week that employ a new methodology to reduce contango:

Each of these commodities and commodity families are already covered under the iPath brand. But these new ETNs don’t just duplicate the existing offerings. The new funds are benchmarked to Barclays Capital Pure Beta Indexes, which are designed to minimize the effects of contango.

Most commodity indexes sell their futures contracts at predetermined intervals as they approach expiration in order to avoid taking delivery of actual commodities. The proceeds from those sales are then invested in longer-dated contracts so as to maintain exposure to whatever commodity the index tracks. That systematic rollover exposes most commodity indexes to contango; longer-dated futures contracts are often more expensive than the current spot price. This can slowly erode the value of the index. Contango can be particularly pronounced in indexes that simply roll into the next near-month contracts.

The existing iPath ETNs use that traditional methodology. But the new Pure Beta ETNs employ a rules-based methodology that allows futures sales to be rolled into futures contracts with different expiration dates.

The new methodology used by the Pure Beta ETNs identifies the average price of the first 12 futures contracts weighted by open interest, called the Front Year Average Price (FYAP). Each contract is than ranked according to how closely it tracks the FYAP, excluding any contracts that aren’t sufficiently liquid. Finally, contracts that are experiencing price distortions because of short-term supply and demand tensions are excluded.

Finally, funds are allocated to one futures contract per commodity that best represents the returns for that commodity.

I’m interested to see how these new Pure Beta products fare. Other contango-minimizing products such as PowerShares Optimum Yield funds, Teucrium’s line of funds and the United States Commodity Index Fund (NYSE: USCI) have all met with mixed success. But these new funds are the first to adopt such a straightforward approach to mitigating the effect of a sloping futures curve. If these new products prove effective at minimizing contango, they’ll likely become the go-to products for ETP investors looking to trade on commodities.

What’s New

In addition to its new Pure Beta products, Barclays also launched iPath Seasonal Natural Gas ETN (NYSE: DCNG). Most natural gas funds on the market invest in a basket of futures and roll on a monthly basis. The index tracked by iPath Seasonal Natural Gas ETN will consist of a single futures contract that expires in December and rolls annually.

First Trust, best known for the quantitative strategies employed by many of its products, also pulled off a bulk launch last week. Of the 13 exchange-traded funds (ETF) that hit the market, nine are internationally focused and the remainder are US-focused ETFs.

The nine international funds are:

First Trust’s four new domestic funds fill out its stable of US-focused offerings, which already includes large-cap and core small- and mid-cap funds. The new funds are:

All of the funds use a benchmark provided by Standard & Poor’s. But rather than simply tracking the benchmarks, an enhanced selection methodology is applied to the index constituents. In the growth-oriented funds, component stocks are ranked according to growth measures such price appreciation and sales-to-price ratio. The portfolio holdings in the value-oriented funds are ranked by value measures are such price-to-book and return on assets. The highest ranked components are then grouped into tiers; the higher tiers of stocks receive the largest allocations.

That enhanced indexing methodology–not exactly passive management but not crossing the line into active management–has produced impressive returns for existing AlphaDex funds. Most of those funds have significantly outperformed their benchmarks by eliminating the biases inherent in capitalization-weighted methodologies. This indexing methodology also captures a fair bit of momentum, which certainly doesn’t hurt performance either.

The real drawback to the AlphaDEX line of funds is that they are significantly more expensive than their plain vanilla peers. Expense ratios on the new funds run from 0.70 percent on the domestic offerings to 0.80 percent on the international fare. Nevertheless, based on the great success of First Trust’s funds, I believe price tag is worth it. At the end of the day the funds’ screening process means that only high-quality companies are included in the portfolio.

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