Posted on 06/23/2011
On April 21st, 2011 Barclays launched their series of "Pure Beta" iPath Commodity products, which are designed to provide similar exposure to commodity markets as does their pre-existing commodity inventory, but while also offering a structure that can mitigate the impact of negative rolling yields within the commodity futures market (i.e. contango). There are of course both pro's and con's in using the futures market with which to structure a commodity index. Among the pro's would be general liquidity and the ability to own exposure to an asset without taking physical delivery of that asset. Neither of those benefits should be understated as many commodities don't store particularly well by conventional means, and the intuitive "markets" we might otherwise turn to aren't particularly efficient. 42-gallon drums of Oil don't fit nicely in a safety deposit box or basement, and the local Wawa is far more comfortable providing an "ask" for a gallon of Gasoline than a "bid" on a barrel of Oil.
However, there are nuances regarding the futures market that can fall into the "con's" column as well, the impact of contango within futures structure at times is chief among them. What was once viewed more as a subtle idiosyncrasy of the commodity futures market became far more mainstream over the past year when Bloomberg BusinessWeek ran with a cover story, "Amber Waves of Pain," explaining how negative rolling yields in the commodity markets (read: contango) have impacted the performance of many commodity-based funds. If contango is not already well entrenched within your ETF vocabulary, please visit the article that was publised on June 16th titled "A Commodity Issue: Contango and Backwardation", as otherwise we'll press on toward the new ETN products within the iPath family with the understanding that their primary difference with regard to existing iPath commodity funds is the attention given toward mitigating negative rolling yields caused by contango within the term structure of a futures market.
The Barclays Pure Beta Indices afford the ability for an index (or note tracking the index) to "roll" into futures contracts with varying expiration dates. Many commodity funds, including the 1st generation iPath notes, tracked indexes that "rolled" on a pre-determined schedule, often into the near-month contract regardless of the likely implications regarding the term structure and expected rolling yield. The "Pure Beta" methodology employs a four-step selection process to evaluate each contract with expiration dates within the next 12-month window for potential inclusion within the index. The evaluation process is repeated each month and the goal of the methodology is to allocate toward the futures contract that is "most representative" of the returns for that commodity. The process includes liquidity and "dislocation" filters, which are briefly described within the graphic below. The contract ultimately chosen is that which offers the lowest "tracking error" to the commodity market it follows while not failing either the liquidity or dislocation filters.
In April a total of 18 funds were added to the iPath family of ETN's, ranging from broad-based commodity products, sector-based commodity products and 10 notes that track individual commodity markets. The full inventory of "Pure Beta" products is provided in the graphic below.