Tuesday, August 3, 2010

Ahead of the Press…Again

In the July 26th issue of Businessweek, the feature article titled “Amber Waves of Pain” attacks the commodity Exchange Traded Fund (ETF) market. They note that investors were “angry” about certain ETF investments that did not perform as expected including the U.S. Oil Fund (symbol: USO). This was mostly due to a condition in commodity futures markets known as “contango,” where longer dated futures contracts are more expensive than near term contracts for the same commodity. USO and other commodity ETFs are constructed to buy contracts that are closest to maturity, and continuously purchase new near term contracts when they are about to expire. This process effectively reduces profits when contango exists, since the ETF is forced to purchase the more expensive future contracts that lose money when they are about to expire, resulting in something called “negative roll yield.”

Additionally, many commodity index funds reinvest their contracts between the fifth and ninth business days of the month. Because this rebalancing is well known by other traders, who are not bound by specific roll dates, they game the system and make it more expensive to conduct these rolls. These traders buy and sell before the expected ETF roll which drives up the price of the next futures contract while driving down the price of the expiring contract. In the end, the purchasers of certain ETFs lose.

However, here at Pinnacle, this is old news. In March, we recognized the inherent problem in many commodity ETF products and pro-actively searched for alternative products. This search led us to the E-TRACS UBS/Bloomberg CMCI Index Exchange Traded Note (symbol: UCI) which we believe is the most attractive commodity index option available at this time. UCI is constructed in a fashion that staggers the purchase of futures contracts at different maturities ranging from 3 months to 5 years, rather than just buying the closest contract to maturity. This helps to reduce the negative roll yield effect when contango exists. Additionally, UCI is constructed to slowly rebalance small percentages of future contracts every day. This helps prevent other traders from manipulating the price of the futures contracts. UCI has outperformed our previous holding by 150 basis points (1.5%) since we purchased it. We expect the marketplace to continue to develop new approaches to manage negative roll yields. This is another instance in which Pinnacle was ahead of the press…again.

For a more in depth look at UCI, please see the following Article of Interest on our website.