USCI: Our Preferred Commodity ETF Is All About Backwardation

By Abraham Bailin

Morningstar's Thesis
Commodities have seen steadily increasing demand thanks to the diversification and inflationary hedging benefits that they provide. At the same time, population growth and fundamental economic drivers in the emerging markets should serve as tailwinds for commodity prices over the long-run.

The proliferation of exchange-traded products has afforded investors convenient broad commodity exposure, but there are a number of access vehicles to turn to. Most of these offerings use futures contracts, and despite macroeconomic tail winds, futures market mechanics have caused poor tracking relative to spot prices. Some of the newer products use dynamic strategies to maximize tracking of underlying commodities and even seek a little alpha. Of these products, USCI is our favorite.

Suitability
United States Commodity Index (USCI) is our preferred broad commodity offering. The fund maintains two objectives: It provides exposure to the most important and liquid physical commodities in the global economy and attempts to achieve higher risk-adjusted returns relative to funds tracking traditional commodity indexes. For investors looking to use commodities exposure as a hedge or as part of an asset-allocation strategy, this fund does the job.

USCI represents a proxy for the broad commodities space by holding futures contracts rather than equity securities. The product will hold contracts with expiration dates as far out as 12 months, as it seeks to maximize gains or minimize losses posed by the shape of the futures curve. The methodology provides an outlet for investors who want broad commodities exposure but don't want to have to worry about how the daily dynamics of the futures market are changing.

Commodities have provided an excellent hedge against unexpected inflation and currency debasement. They have also been shown to offer the benefits of diversification thanks to their low correlation with traditional asset classes. Commodities-futures markets are highly speculative and volatile in nature, so we make no explicit long-term predictions on prices. For those interested in establishing a core futures-based broad commodity position, however, USCI is our pick.

Fundamental View
Market liquidity and the absence of carrying costs can make using futures a more convenient way to invest in commodities than owning them directly. The catch is that the futures curve--the prices of contracts at progressively distant expiration dates--can take an upward slope (known as contango) or downward slope (known as backwardation). This can cause futures and spot returns to decouple, known as basis risk. Many funds roll contracts at predetermined intervals, leaving them vulnerable to losses when the shape of the futures curve shifts over time.

During the 1990s and early 2000s, commodity markets were mostly backwardated, meaning that even if spot commodity prices remained flat, rolling a futures position produced a positive yield. The mid-2000s saw a systemic shift, as futures markets moved into contango, crippling traditional commodity futures indexes. Even though spot return for the Dow Jones UBS Commodity Index remained essentially flat, the futures-based index fell more than 8%.

USCI maintains a dynamic futures strategy, looking to minimize losses associated with contangoed markets and to maximize the gains of those in backwardation. While USCI is neither the first fund in the broad commodity-futures ETF space nor the first fund to use a dynamic futures strategy, its twist on this strategy may prove optimal.

USCI delivers broad commodities exposure while maximizing backwardation by sector rather than anchoring itself to specific commodities. A number of commodities fall into each subsector classification. Thus, the index can both satisfy sector representation and maximize month-over-month momentum by shifting in and out of the various commodities in each subsector while holding contracts whose expirations look to maximize the implied roll yield of backwardated markets. USCI hopes that this added level of flexibility will give it an edge over its peers.

Because of the lack of backwardation across commodity futures markets, potential investors in USCI's portfolio should have an investment thesis that rests upon a very positive outlook for future commodity demand. Economic and population growth in the emerging markets will continue to place greater strain on ultimately limited supplies of the world's natural resources. The U.N. projects an 11% global population increase by 2020 and a 20% increase by 2030. At the same time, the global middle class' surging growth will compound demand for food and energy as diets and transportation habits become more like the West's.

The largest threat to this story is a major slowdown within the emerging markets, namely China. The nation is a chief demand-side driver of virtually all commodities and has staked its legitimacy on sustained 8% GDP growth. China has engaged in a tremendous infrastructure binge to keep up the pace, but lightened commodity demand caused by a Chinese slowdown could provide substantial headwinds for USCI and commodity prices in general.

Portfolio Construction
USCI tracks the SummerHaven Dynamic Commodity Index, which holds 14 of 27 eligible commodities. Every month, the index targets the seven most heavily backwardated commodities and then the seven commodities with the largest annual price change, but it will make adjustments to ensure representation of all six commodity sectors: energy, precious metals, industrial metals, grains, softs, and livestock. Portfolio weightings will shift from month to month in an alpha-seeking pursuit of backwardated markets. USCI takes long positions in the futures markets of its target commodities and margins its positions with U.S. Treasury securities, cash, and cash equivalents, which are held as collateral.

USCI is a partnership, so it doesn't pay entity-level taxes. Shareholders are required to pay federal income taxes on their share of the fund's taxable income. Taxes must be paid regardless of whether distributions have been made, and the sponsor has indicated that it intends to not make distributions. Annual gains in the fund will be taxed regardless of whether you sell the fund with all gains taxed 60% at long-term capital gains rates and 40% at prevailing short-term rates. Investors receive schedule K-1s for tax-filing purposes, which can complicate the filing process for those unfamiliar with partnership-reporting requirements.

Fees
This fund charges a 0.95% fee in addition to variable trading expenses, making it one of the priciest commodity offerings on the market. Last year its trading expenses added nearly 30 basis points to the final tab. While the fund carries a relatively steep price tag, the alpha produced by its dynamic methodology should more than compensate for the higher fees. Over the past year, USCI has gained 31%, while PowerShares DB Commodity Index Tracking (DBC) returned about 22%.

Alternatives
DBC stands as USCI's primary competition. It also attempts to limit the impacts of contango by purchasing futures contracts with optimal positions on the futures curve. The ETF is far more liquid and a bit cheaper than USCI but maintains a static allocation. Thus, the two funds are likely to post noticeably different returns over time, despite high correlations.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.