HardAssetsInvestor

Written by Lara Crigger  |

August 19, 2010

Taking The Active Approach To Commodities ETFs

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K. Geert Rouwenhorst and Kurt Nelson of SummerHaven Index Management, LLC explain how to go beyond passive in commodities exposure.

Last week, U.S. Commodity Funds launched its new U.S. Commodity Index Fund (NYSE Arca: USCI), which some have called the "contango killer." Based on the SummerHaven Dynamic Commodity Index, USCI tracks an active, futures-based benchmark specifically designed to zero in on the most advantageous part of the futures curve for investors.

The index is the flagship benchmark from investment firm SummerHaven Investment Management, LLC, which has a remarkable pedigree in the commodities space. Its founders include a professor whose research helped spark the commodities boom, a quantitative investing expert and the former heads of commodities trading and indexing for UBS.

Founding partner Kurt Nelson ran UBS' commodity index business, where he spearheaded efforts to bring several ETNs to the market and acquire and integrate AIG's commodity index business. Co-founder K. Geert Rouwenhorst is a finance professor at Yale's School of Management and deputy director of the university's International Center for Finance. He is perhaps best known for his landmark paper with Gary Gorton that revealed commodities as a source of positive returns uncorrelated to stocks or bonds.

Recently, HAI Associate Editor Lara Crigger chatted with Nelson and Rouwenhorst about the rationale behind the SummerHaven Dynamic Commodity Index.

Crigger: Let's talk about the effect contango has on commodity returns. There's a perception among many investors that contango inherently means lower returns in the commodity space, but that's not exactly true, is it?

Rouwenhorst: When people say contango drives down returns, I think it follows from observing that, say, the spot price of oil goes up by 10 percent but their oil futures ETF only goes up, say, 3 percent. So they ask, "Why is my fund not up by the same amount as the spot price of oil? Well, maybe that's caused by the contango."

In some ways, it is caused by the contango, but it doesn't really mean that the return you earn as a futures investor is necessarily unfair. In fact, you could argue that the return you thought you were getting on the spot was unrealistic or unfair. It ought to be expected that the futures return underperforms the spot return by about the cost it requires for you to store oil.

Nelson: That said, we do think curve shapes for things like contango are informative. It doesn't mean that you will lose money, and it doesn't mean a price is unfair, but it does tell you information.