The Rise And Fall Of Commodity ETFs

The Barclays iPath Bloomberg Commodity Total Return ETN (DJP) sought to overcome the K-1 problem by packing commodity exposure as an exchange-traded note (“ETN”) instead of a fund. As notes (debt security), ETNs were bonds that did not own any commodity futures, but the bond’s value was linked to a commodity futures index. However, this attempt at fixing the problem created additional problems. As bonds, ETNs carry the risk of issuer default, and the cost of hedging their positions has caused many issuing banks to stop issuing additional ETN shares. Issuer default is devastating for ETNs, as demonstrated by the collapse of Lehman Brothers and its Opta brand of ETNs. Additionally, when issuers stop providing additional shares, the primary mechanism to control trading prices disappears, rendering them broken products. ETNs are not the solution.

The First Trust Global Tactical Commodity Strategy ETF (FTGC) was the first broad commodity ETF to overcome the K-1 problem. Launched in October 2013, the fund pioneered an investment approach whereby its only direct investment was in a wholly-owned offshore subsidiary, allowing it to be a 40 Act fund that issued 1099s. The offshore subsidiary was then responsible for handling all of the purchases, sales, and rolls of the needed futures contracts. Most newer commodity ETFs have adopted this approach.

Another problem with commodity funds is that investing in futures contracts does not provide the same performance as something tracking spot prices would. That is because all futures contracts have an expiration date, and to maintain exposure to the commodity, the fund must sell the expiring contract and replace it with another contract with a later expiration date. Most of the time, the value received from the sale is less than the amount needed to buy the new one. This pricing structure, known as contango, causes the fund to lose money every time it rolls its contracts and steadily lose ground against spot prices.

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Disclosure:

Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either ...

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