The challenge in creating commodity ETFs

As ETFs continue to gain popularity among investors, fund providers are working to come out with new products and innovations. Today, ETFs come in a wide range of flavours, with indexes constructed to accommodate different factors and alternative, non-market-cap weighting schemes.

But that variety in indexing is only possible when there’s an underlying system to follow. And the lack of a system makes ETF construction especially challenging for one major asset class: commodities.

According to ETF.com contributor Dave Nadig, most index methodologies can be boiled down to one of two key ways of selecting and weighting securities:

• Their “importance” in capturing an asset class, such as market cap for equities and issuance for bonds; and
• A belief system on what will go up, which includes factors like growth or value

“But in commodities, there’s really no agreement on what ‘importance’ means,” he said. Indexes like the S&P GSCI, for example, focus on how much of a commodity is produced. Other indexes, like the  Bloomberg Commodities Index, add a measure of liquidity and limit over-investment in any one sector. And others just use equal weight.

“[T]here’s not even common agreement on what to include,” he added. Some commodity indexes may exclude gold, while others may leave out livestock.

Adding to the confusion is the complexity surrounding how one can invest in commodities. The vast majority of commodity funds use futures, which gives rise to considerations like how to deal with contango and backwardation, selecting which contracts to own, and how to roll them.

All these, Nadig argued, make commodities the final frontier for ETF creation. “So if some enterprising young academic is hankering to make a name for themselves [in ETF innovation], that’s what I’d focus on.”