As the ETF world has surged ahead in recent years, perhaps no corner of the industry has generated as much interest as the commodity space. The introduction and proliferation of exchange-traded commodity products has granted many investors access to a section of the investable universe that was previously beyond their reach. The democratization of an asset class with the potential to add valuable diversification benefits to traditional stock-and-bond portfolios has been met with open armsand open wallets. Inflows to commodity ETFs topped $30 billion in 2009, and the cash flows have remained strong for much of this year as well.

But the impressive expansion of the commodity ETF space hasnt occurred without a few growing pains. Commodity ETFs have been the targets of some significant investor frustrations and unflattering press coverage. The most scathing critique came from BusinessWeek. which detailed the confusion that exists related to the nuances of futures-based exposure, and issued a blanket warning against investing in exchange-traded commodity products [also read Five Things BusinessWeek Didn’t Tell You About Commodity ETFs ].

Much of the frustration and confusion has centered around the manner in which these products achieve exposure to the underlying commodities. While there are a handful of physically-backed commodity products, the properties of most natural resources make such a structure impractical. The costs of storing and transporting natural gas, for example, would be significant and would make a physically backed natural gas ETF too costly to implement. The stockpiling of agricultural commodities such as livestock would be a disaster for similar reasons.

When physical storage is either prohibitively expensive or a logistical nightmare, many ETFs offer exposure to commodities through  futures contracts. And while the correlation between futures contracts and spot prices is often very strong, some investors have struggled to understand that the prices of futures-based commodity ETFs wont move in unison with spot prices. In order to avoid taking delivery of the underlying assets, commodity funds roll futures contracts on a regular basis, selling those that are nearing expiration and buying longer-dated contracts. When futures markets are contangoednear month futures are cheaper than those expiring further into the futurethe roll process can mean selling low and buying high, thereby creating some significant headwinds for investors [also read How Contango Impacts ETFs ].

Another issue facing diversified commodity ETFs is the manner in which individual commodity allocations are determined. Historically, most commodity products have replicated indexes that maintain a similar composition regardless of the economic environment. The first generation of commodity funds were often weighted by global production of the commodity in question and were too static, says John Hyland, the CIO of United States Commodity Funds. The second generation of commodity funds took a more diversified approach but was again too static to take advantage of changes in the market; many of these funds remain heavily concentrated in certain sectors, which can result in a significant concentration of assets.

Hyland is one of the forces behind what he considers to be the third generation commodity ETF product that recently hit the market: the United States Commodity Index Fund (USCI ). This funds unique methodology has attracted interest from investors frustrated by the outsized impact of contango on returns and looking for a better way to tap into a promising but also perilous asset class. The key difference is that you have to make the cut to be included in the fund, unlike in the second or first generation of commodity funds, says Hyland.

Under The Hood

The new fund, the result of a partnership between USCF and SummerHaven Investment Management, seeks to offer investors a way to invest in a diversified basket of commodities while using a novel approach that has never before been accessible within the ETF wrapper. The structure of USCI has its roots in the groundbreaking research paper Facts and Fantasies About Commodity Futures. co-authored by SummerHaven founder and Yale University Professor K. Geert Rouwenhorst and Gary Gorton, a fellow professor at Yale. In the 2005 paper, the authors concluded that portfolios comprised of commodity futures had the ability to deliver equity-like returns with bond-like volatilitya combination that is obviously appealing to investors. Two years later, they were part of another research paper illustrating that a hypothetical portfolio consisting of backwardated futures contracts would have outperformed contangoed and equal-weighted portfolios by a considerably margin [see all the Commodity ETFs here ].

Through his research, Rouwenhorst concluded that the slope of the futures curve can provide some insights into the inventory levels of various commodities. This is something that follows from economic theory, in particular the theory of storage, says Rouwenhorst. When inventories are low, users of commodities may be willing to pay a premium for owning a spot commodity relative to futures prices in order to avoid facing a stock out. You can only heat your building with physical heating oil, not futures on heating oil. So when inventories are low, you are willing to pay a premium to own spot heating oil to avoid the risk of running out. This premium is sometimes called the convenience yield, and can lead to a backwardated futures curve.

That theory was a major force behind the construction of USCI. The fund tracks the SummerHaven Dynamic Commodity Index. a benchmark comprised of 14 futures contracts selected on a monthly basis from a list of 27 possible futures contracts. In order to select the underlying holdings, the 27 most liquid commodities that trade on major exchanges around the world are ranked from most backwardated to most contangoed. The seven commodities exhibiting the steepest backwardation (or most mild contango) are then included in the index. The remaining commodities are then ranked by price increase over the past year, regardless of whether the related futures market is backwardated or contangoed. The seven commodities with the best performance over the last year are included to round out the index, which is rebalanced on a monthly basis [read What Every Investors Should Know About Commodity ETF Investing ].

So while the first screen will exclude commodities for which the futures market is severely contangoed, USCI wont necessarily avoid assets with an upward-sloping futures curve; commodities with the greatest upward momentum will have a place in the underlying index, a feature that also stems from Rouwenhorsts research. The important observation is that we would have taken 14 commodities based on inventories if available, but aggregate inventory data are often not available in real time and are often revised afterwards, says  Rouwenhorst. My research with professors Gorton and Hayashi has shown that backwardation and annual relative price change are both price-based measures of inventories. So we chose half based on backwardation and another half based on momentum.

It is also important to note that the fund will not hold any commodity during the final month of the contract and that it does not discriminate against long or short term futures contracts; whichever length offers investors the greatest potential to pick up roll yield. But the fund does not cycle in and out of different commodity contract lengths in order to take advantage of changing levels of backwardation. Instead, purchased are held until either the final month of the contract or until the commodity in question no longer makes the cut for inclusion in the index. Additionally, for diversification purposes, the index will ensure that each of the six different commodity sectors (grains, softs, industrial metals, precious metals, agricultural, and livestock) are always represented by at least one futures contract each month [see The Complete Guide To Commodity ETF Investing ].

Unlike most commodity products, USCI has the flexibility to shift individual resource weightings in response to movements in market prices and inventory levels. Other commodity funds have fixed weights and hope that they got it right, notes Kurt Nelson of SummerHaven. USCI is the first ever fund to look at low inventory commodities with a dynamic weighting methodology.

Hot Start

USCI launched less than two months ago, so it is difficult to draw any meaningful conclusions from its performance history. But over that relatively short time period the fund has already distanced itself from some other popular commodity products. Between its launch on August 10 and the end of the third quarter, USCI gained about 8.6%. During that same period the ultra-popular PowerShares DB Commodity Fund (DBC ) was up about 3.2%, while the iPath Dow Jones-UBS Commodity ETN (DJP ) gained 3.7%. According to Nelson, a comparison of the indexes underlying commodity ETFs shows a longer history of outperformance; using historical index data over the last 20 years, the SummerHaven Dynamic Commodity Index outperforms traditional commodity indexes at an annualized rate of 10% to 12% [see Five Creative Ways To Use Commodity ETFs ].

Its worth noting that while USCI will rebalance its holdings monthly based on price movements and changes in the slope of various curves, the fund is not actively-managed. Rather, it seeks to passively replicate a rules-driven index. Unlike all the first and second generation commodity indexes, the index underlying USCI is dynamic in its commodity weightings, notes Hyland. However, that index follows very specific rules and is not the result of human judgment or intervention.

Some have argued that the tremendous increase in new product launches illustrates an ETF bubble that will ultimately lead to a wave of consolidations and perhaps closings. But as the launch of USCI shows, there are still a lot of good ideas working their way through the pipeline, continuing the evolution of existing products and refining the manner in which investors are able to access popular asset classes.

USCI is, of course, not without risk. Commodities have the potential to exhibit significant volatility, particularly in uncertain economic environments. But the investment thesis behind the fund is compelling, particularly for investors with a longer time horizon looking to add diversifying agents to traditional stock-and-bond portfolios. It might not be the most popular commodity ETF out therenot yet at leastbut for those searching for exposure to broad commodity indexes, its certainly worth a closer look.

Disclosure: No positions at time of writing.

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