The Commodity Index Reborn
September 29, 2009
By Lara Crigger
As readers of HardAssetsInvestor.com know, the Commodity Futures Trading Commission spent all summer pushing for tighter regulation of commodity ETFs, which the agency blames (rightly or wrongly) for running up energy prices last year.
For the CFTC, it's not a question of whether they should impose new regulations, but how much: Position limits, tighter regulation of swaps contracts and higher capital and margin requirements for derivatives are all possibilities currently on the table.
Exactly what shape the new rules will take will be decided later this fall, but already the debate has sent convulsions throughout the industry. Several futures-based exchange-traded products, like the U.S. Natural Gas Fund (NYSE Arca: UNG) and the iPath DJ-UBS Natural Gas ETN (NYSE Arca: GAZ), suspended the creation of new shares (although UNG has recently reopened). And at least one product, the PowerShares DB Crude Oil Double Long ETN (NYSE Arca: DXO), was entirely liquidated.
But what about the indexes themselves? After all, an ETF is really only as good as the index it tracks, and if commodities indexes don't evolve, how then can the products?
Last week, several indexing companies announced their ideas for new commodities benchmarks, making it clear they didn't plan to wait around for the CFTC to get its act in gear. But will any of their approaches work?
The CRB Index, Redefined
Last week, Thomson Reuters and Jefferies & Co. launched a revamped version of their famous CRB Index that focused not on commodity futures, but equities.
The original Reuters-Jefferies CRB Index, one of the most widely followed indices around, tracks 19 futures contracts from across the commodities spectrum, including crude oil, natural gas, industrial and precious metals, and softs.
In comparison, the new benchmark, the Thomson Reuters/Jefferies In-The-Ground CRB Global Commodity Equity Index, tracks 150 commodity producers and distributors worldwide. It includes equities of 50 energy companies, 35 agricultural producers, 35 industrial metals firms and 30 precious metals companies. The fund's associated ETF, sponsored by ALPS Funds, launched last week under the ticker CRBQ. (Check out the CRBQ prospectus here.)
CRBQ definitely isn't the first equity-based commodity fund: It has competition from existing broad-based ETFs like Van Eck's Market Vectors RVE Hard Assets Producers ETF (NYSE Arca: HAP), and iShares' S&P North American Natural Resources Sector ETF (NYSE Arca: IGE).
But the new Reuters/Jefferies index does mark the first equity-based benchmark launched specifically as a reaction to the CFTC's moves. It's "an alternative for investors looking for exposure to commodities without exposure to the commodities futures market," said Art Hogan, chief market strategist at Jefferies & Co, to the WSJ last week.
On paper, it's not a bad idea: A pick-and-shovel commodities index does avoid the volatility common to the derivatives market, and it places any ETFs tracking it outside the reach of the CFTC. Plus, in some cases, equities are the only way to score exposure to illiquid or difficult-to-access markets, like coal or steel.
But equities-based commodities ETFs have their own issues to contend with—namely, equity risk. As Larry Swedroe pointed out in last week's interview, equity-based funds tend to correlate higher to equities than to commodities. Stock-based ETFs simply aren't the "pure plays" on commodities that many investors are looking for.
S&P Goes Overseas
So perhaps the answer isn't to take commodities ETFs out of the futures market-but to get them out of the U.S. entirely.
That's the thinking of Standard & Poor's—the people behind the world's largest commodities index, the S&P GSCI. Recognizing that increased oversight of commodities markets at home will likely push trading to less regulated markets overseas, S&P has begun "seriously exploring" a new commodity benchmark that would forgo any U.S. exposure whatsoever.
The S&P GSCI index mostly tracks futures traded on U.S. commodities exchanges—particularly West Texas Intermediate crude oil, in which it has 39% of its holdings. An ex-U.S. version, on the other hand, would track European contracts, like U.K. Brent crude oil futures, the LME metals contracts, or the softs available on the U.K.'s Liffe exchange.
Apparently S&P had considered launching such a benchmark as far back as 2007, but "it's accelerating a little more, as people fear potential regulations in U.S. financial futures markets," said director of commodity indexing Michael McGlone to Bloomberg. S&P hopes to launch the new index by early next year.
Of course, creating an ex-U.S. commodity fund is easier said than done. S&P has been on the hunt for two years for overseas futures contracts offering sufficient liquidity—to no avail.
"We keep hitting bottlenecks with liquidity issues," McGlone told Reuters. "We'd consider any futures, as long as they pass liquidity constraints, as long as they can be actively traded by foreign investors."
That they haven't found anything in two years of looking is quite telling.
In addition, there's the issue of currency risk, meaning that investment returns are subject to the whims of exchange rate fluctuations. So far, exchange rates have worked in U.S. investors' favor, as the falling dollar has helped to boost international returns. But should the dollar rally or should foreign currencies depreciate, those same overseas investments could be hit hard.
Platts Gets Physical
What if the solution to the commodities ETF dilemma isn't to find the right equities or futures—but to avoid them altogether?
That's the solution floated by energy information giant Platts, who told Reuters it was contemplating the creation of a new, all-physical commodities index that would offer pure exposure to oil, metals, gas and coal.
"The appetite to be exposed to energy prices is fairly large," said Jorge Montepeque, Platts' global director of market reporting. In particular, he cited increasing demand from financial institutions and hedge funds, who've started looking to the physical spaces as a way to escape the volatility inherent in the futures market.
"There is easy access to futures instruments," he said. "Hence the market wants to have the same easy access to the physical instruments."
But on the other hand, "the reason for the volatility of the futures markets is that the physical markets are volatile-not the other way around," said Chris Cook, former compliance and market supervision director of the International Petroleum Exchange, in an interview with HAI on Monday.
"The reason why the likes of the hedge funds are looking to join the investment banks in the physical market is that in this way, they can be 'on the inside pissing out,' as Lyndon Johnson put it," he added. "It will make the physical market that much more volatile."
As for the likelihood of Platts' proposed index ever making it to launch, says Cook, "I think the regulators might take a bit of convincing."
Will It Work?
Only time will tell if any of these new indexes can successfully circumvent the CFTC's impending rule changes—or even make it to launch. But just the fact that indexing companies are thinking about this may bode good tidings for commodities ETF investors.
As adviser Larry Swedroe told HAI in an email last week, "When you impose regulations like those suggested, and there is demand for the product, smart people will find a way to deliver it."
