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John Hyland

Here Come Sophisticated Commodity Indexes

United States Commodity Funds LLC is best known for its oil fund, among the earliest exchange-traded commodity funds offered in the United States. Last year the firm launched the diversified US Commodity Index Fund. Industry analysts voted this product and its underlying benchmark, the SummerHaven Dynamic Commodity Index Total Return, the most innovative ETF and index of the year.

Why is this index innovative? What does the growing sophistication of commodity indexes mean for investors and for managed futures? We asked John Hyland, chief investment officer at United States Commodity Funds. He's been with the firm since 2005. The oil fund started operations in 2006. USCI fund started in August 2010 and returned about 41% since inception (through March).

The firm has other funds as well and around $5 billion in assets. See Top Ten for USCI and other diversified commodity fund market caps.

"I don't know if the number of commodity ETFs will double in the next few years but I expect assets under management will double or quadruple outside the gold space."

Opalesque Futures Intelligence: How do you deal with the problems of commodity index investments, in particular the built-in losses from rolling the contracts in contango markets?

John Hyland: There are three generations of commodity indexes, with large differences in design and long-term results. S&P GSCI exemplifies the first generation of indexes, which have three features. One, they assign static weights to each commodity; two, the weights are based on a criterion other than producing a desirable investment outcome; and three, they only buy contracts in the front or second month, meaning they get the maximum impact of contango and backwardation. The second generation of commodity indexes came out about five years ago. They share the first two attributes of the older indexes but differ in investing their holdings away from the front or second month contract, particularly when a commodity is in contango. This one simple change allows second generation indexes to outperform the older indexes by 5%-plus a year.

OFI: What differentiates the third generation?

JH: The third generation, which came out in 2009, also play the futures curve like the second generation, but add rules-based methodologies to adjust the mix and weightings of commodities. This type of index may lower the weight or even assign zero weight to a commodity that is badly in contango or displays some other trend suggesting it is not going to perform strongly. Third generation indexes outperform the first generation by as much as 10% a year or better. We're talking serious money!

OFI: Is this active management?

JH: No, this is not active management. I prefer to describe the third generation as dynamic indexes, in that they can change which commodity to hold, the weighting, and where on the curve to buy the contracts, according to a set of rules.

OFI: If the more sophisticated indexes do not generate alpha returns, how do you describe what they produce?

JH: Dynamic index returns are not alpha, but the funny thing about the commodity world is that there really is no such thing as just simple beta. While every large-cap stock index produces pretty much the same result, every commodity index produces a very different result depending on their weighting scheme and where on the curve they buy their contracts. Each one is beta, but not all betas are created equally. The newer versions could be called "enhanced beta".

OFI: You launched the US Commodity Index Fund last August. What makes the underlying index third generation?

JH: The index, built by Yale professors Gorton and Rouwenhorst, is from SummerHaven. It comes with quantitative algorithms that every month pick the best 14 commodity futures contracts out of a universe of 27, based on ranking for backwardation and other criteria. This does not mean that you can't have a down year, but it is a better mousetrap. We're the first, but in a year there may be half a dozen such index products.

OFI: Like the early indexes, third generation indexes are long-only. When commodities go down, as they did in recent weeks, don't all indexes follow suit?

JH: If you believe commodity prices will go down for the next 12 months, then yes, commodity index investments won't do well. Third-generation versions will do better than the GSCI, but that may mean we're flat while GSCI makes a loss. But how do we know that your belief will turn out to be correct? It is entirely possible that commodity prices will go up over the next 12 months.

OFI: CTAs can go short, protecting against down phases of commodity cycles. Won't CTAs always have this advantage over indexes?

JH: Probably long/short or long/flat commodity indexes are the next wave. Long/flat indexes have the flexibility to go to cash-by contrast, third generation indexes stay 100% invested by changing the weights to reduce exposure to the commodities that are not promising. For the investor, long/short is a different animal from getting the best commodity exposure you can get because you believe commodities will be in a sustained bullish phase. If you go for long/short, you're saying you are interested in the manager's ability, not in your exposure to commodities.

OFI: What does the availability of enhanced beta in ETFs mean for managed futures?
JH: That could put pressure on CTAs to really deliver alpha returns or get out of the business. We all know that in the equity world there is a problem with closet indexers, who get paid active management fees but really just hug an equity index. Investors would be better off buying an S&P 500 index fund for just 20 basis points. Similarly in the CTA world, people charge 2%-and-20% and tout how much better they are than the GSCI or DJ-UBS. Many of them are truly doing creative things to add real alpha but others are just taking advantage of the weakness of first generation indexes. For the last 10 years all you had to do was use the same commodity weights as the DJ-UBS but avoid buying the first or second month contracts-you looked like a genius! Those days are over. For 85 basis points investors can buy a second generation index that does the same thing. For 95 basis points they can go to the third generation and get a systematically changing basket of commodities.

OFI: What effect will this have?
JH: If your performance is not in the top half of CTAs' and managed futures accounts providers' returns, you are going to get caught in a fee squeeze. The new indexes essentially are picking off the low hanging fruit in the commodity portfolio management space, which is enhanced beta. Nobody will want to pay 2%-and-20% for anything less than true alpha.

OFI: What are the advantages and disadvantages of using second or third generation commodity ETFs compared to CTAs?
JH: ETFs offer low costs, plus daily liquidity and transparency. You can buy or sell them any time during the day and you will always know what they own. On the other hand they are not customized to any single investor's particular needs. That might matter to an investor who already has a lot of exposure to a particular commodity and wants to avoid getting more through a diversified commodity fund or who wants a particular tax strategy. Finally, as I mentioned, these funds are not chasing alpha. If you find somebody who can deliver real alpha return on an after-expense and risk-adjusted basis, that may be a worthwhile alternative.

OFI: Will commodity ETFs continue to grow?
JH: Commodity products are a relatively young and small part of the ETF world. There may be 70 to 80 commodity ETFs altogether, with around $85 billion in combined assets-and the physical gold funds account for maybe $65 billion of that. The rest of us share the remaining $20 billion. For perspective, the market cap of just one company, Exxon, is $400 billion. We are tiny and there's no way to go but up in terms of assets under management. I don't know if the number of commodity ETFs will double in the next few years but I expect assets under management will double or quadruple outside the gold space.

OFI: What comes next?
JH: By the end of this year single-commodity ETFs will already cover the most important and actively commodities, so growth in those should slow down. But the move to design better commodity indexes will continue. Another area of new development is the long/short or long/flat strategies, which move even more deeply into CTA territory. I expect a lot of development there, but the offerings will have to prove themselves.