Thursday, August 12, 2010

What happens when you ARE the market?

I see that the folks at US Commodity Funds, who brought us the tremendously popular ETFs USO and UNG, is launching an ETF that is designed to combat the return eroding contangoes observed in many commodity futures. The new fund is called the United States Commodity Index Fund and will track the SummerHaven Dynamic Commodity Index. The Index will re-balance monthly and hold 14 out of a possible universe of 27 commodity contracts on an equal-weighted basis. The selection will be strictly rule-based:

USCI is based on a simple but powerful investment thesis: historical data shows that portfolios comprised of commodities trading in backwardation tend to perform better than broad-based commodity baskets or commodities for which futures markets are contangoed. The idea behind USCI is that the optimal form of commodity exposure is achieved through positions in backwardated markets or markets that exhibit the least degree of contango.
An explanation: When long-dated futures are trading above the current spot price, the market is considered to be in contango. When then are trading below spot, the market is said to be in backwardation.

Sounds great? Not!

I am sure the backtests worked really well but this is a case of quants gone wild. No doubt, US Commodity Funds hopes that the success of the new ETF will equal or exceed the popularity of USO and UNG. Were this to happen, the buying pressure put on some of these commodities, which can be quite thin and illiquid, would create enormous return eroding price distortions.

As an aside, you are just begging for the Street to front-run you given the rule-based index construction approach – not a good idea.

Too many ETFs?
In early July, TickerSense reported that the number of US-listed ETFs that they track went over the 1,000 mark. Do we really need that many ETFs?

Are they distorting the market and market liquidity?

Could less sophisticated investors be fooled into believing that an ETF representing a narrow, but sexy, segment of the market be more liquid than it really is? Consider this recent Van Eck Global filing for a Minor Metal (read: rare earths) ETF.

Enough is enough. Some of these ideas are ill considered and are accidents waiting to happen.

No comments: