Providers of futures-based commodity ETPs have slammed accusations that roll costs make the products unsuitable for long-term investors.
ETPs that use futures to provide exposure to the spot price changes of a commodity are subject to the cost of replacing existing contracts as they come close to maturity.
If the market is in contango, the selling price of the expiring contract is lower than the cost of its replacement and the fund will incur a loss. Conversely in backwardation, the new contract is cheaper and the fund gains.
The American Securities and Litigation Consulting Group has published a paper Futures-Based Commodities ETFs claiming these costs lead to "pervasive underperformance" which "calls into question the usefulness of these ETFs for diversification or hedging."
The report says: "Only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs."
ETF Securities co-head of European sales Scott Thompson questions the meaning of the alleged underperformance. "What concerns me is this academic perspective, as if it were actually possible to invest in the spot price and investors are somehow losing out on that in these products.
"You can never achieve the spot return in the commodities world. It's a mythical investment objective - you are targeting it but the reality is it costs money to try."
ETF Securities is the biggest ETP provider in Europe according to BlackRock, and has a product range that includes physically-backed commodity ETCs.
Thompson points out these investments, too, hold significant outlays. "In fact, on average it seems to cost a little more to go physical - what you're getting instead is certainty about the cost."
SLCG's report looks at three crude oil ETCs traded in the US and finds that despite a high daily correlation to spot price changes, holding period returns deviated significantly from those that would be expected.
Despite using distinct restructuring methodologies and holding portfolios of different tenors, all funds suffer the same fundamental problem, SLCG says. During periods of contango, negative roll yields erode performance.
Three oil ETCs though are a relatively small sample of the roughly 600 commodity ETPs available across the globe. Thompson says: "The US oil ETCs do not necessarily perform that well versus their European equivalents. I think if you had that conversation in Europe and looked at European ETCs you might find those arguments are far less powerful."
American provider Van Eck recently filed for an ETF based on the Market Vectors Constant Maturity Commodity index with an explicit view to alleviate the effects of contango. A ‘constant maturity' index invests throughout the futures curve instead of just the front month.
ETF Securities meanwhile offers investors a range of maturities. Thompson says: "My own personal read is that if you have a short-term view, you are better off investing at the front of the futures curve because it tends to move more. We also have a series of products that are three months out. The only reason for that is the curve is a lot flatter out there so the roll-costs are smaller. Equally the returns may get smaller, but on a risk-return basis that can look quite attractive."
Deutsche Bank uses an ‘Optimum Yield' mechanism on its ETCs to try both to lessen the worst effects of contango and maximise the positive roll-yield during backwardation. Unlike commodity ETPs that automatically roll over into new contracts of the same length, these products can choose which contracts to buy.
Thompson says: "I guess you're into the argument of how far do you stretch the ETF envelope into active strategies. I think a lot of investors, if they want something quite as active as that, might well go down a traditional active fund management route."
The report shows that the PowerShares DB Oil Fund has underperformed the WTI Crude Oil spot price over the past year, despite using Deutsche Bank's ‘Optimum Yield' methodology. While these more sophisticated strategies do seem to do better than straightforward alternatives, they are still not able to capture spot price returns.
Van Eck Global principal Jan van Eck admits that his company's constant maturity ETF will not match spot prices. He argues: "This is a much closer fit. It'll be good enough."
Thompson adds: "What this article misses is the temporal aspect: commodities markets are sometimes in contango and sometimes in backwardation."
He stresses that despite the obvious downsides, contango does not mean negative or poor returns. "If you take our All Commodities ETF for the fourth quarter of last year, negative roll-yield cost the product an average of 2.7%, but it still yielded 15.8%. In agriculture too, contango was costing just under 2% but the market returned 25%."
Key among the report's findings is that the slope of the term structure - whether a market is in contango or backwardation - is predictable and "serially correlated", meaning that shrewd investors can anticipate an ETF's future performance relative to spot price. SLCG says: "Knowledge of the ETF deviation of the previous month is in itself informative for an investor".
When ETF Securities launched its first tranche of physically-backed industrial metal ETCs, the company suggested that particularly sophisticated investors might want to switch money back and forth between futures-based and physical ETPs according to the market's term structure.
Thompson agues a carry-cost is not "so peculiar" to commodities. He says: "There are similar processes in place in the foreign exchange market, for example. Or you can extrapolate it even further and ask, why invest in active fund management, where a management fee is effectively a cost of carry. People do though, because they get good returns."
As for the principal charge of the unsuitability of futures products for long-term investing, Thompson is unconvinced. "I don't think you can hang a case around the commodities market not being a buy-and-hold type of investment because it has contango. The returns people have received over one, five and 10 years blow that hypothesis out of the water."
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