Wednesday, May 31, 2006

iShares GSCI Commodity Trust GSG files prospectus

Barclay’s iShares filed a prospectus for the iShares GSCI Commodity Indexed Trust. (GSG) The fund will invest in CERF futures which are linked to the total return of the GSCI Excess Return Index.

The GCSI-ER index is calculated as the return from actually investing in the GCSI commodities index. The excess return index accounts for the effects of rolling futures contracts, and of earning interest on margin deposits. The GSG fund is investing in futures that express the total return it would have earned had it passively invested in the underlying contracts of the GSCI index.

The result is that the iShares fund doesn't have to pay the trading costs it would have had to incur if it actually owned and managed the futures contracts themselves. Therefore the iShares fund is more efficient than a fund that directly invested in the underlying futures. This is shows up in a low management fee of 0.75%, and immaterial expected operating expenses. Compared to (DBC), at 1.30% the iShares fund is quite cheap.

However investing in the new iShares fund requires that you agree with the thinking behind the Goldman Sachs Commodity Index [GSCI]. The GCSI is an index of 24 commodities weighted by world production. Goldman Sachs believes each commodity should be weighted in proportion to the amount of that commodity flowing through the economy.

Because commodities can be held in many different ways it is impossible to directly measure the amount of capital dedicated to holding that asset. For a stock you can measure its market capitalization which represents the total amount of capital dedicated to holding that stock. But for commodities, you can't do that. The way to measure economic significance of commodity is to measure its production, which in turn is related to how much capital is dedicated to that commodity.

At this point, theoretical elegance clashes with investment prudence. The worlds most widely produced and traded commodity is oil and related products. Reflecting that, the GSCI has a 73.5% weighting in energy commodities. Of the total index, 45% is weighted to Crude Oil. Of the remaining 27% of the index, 10% is allocated to each of agricultural commodities and industrial metals. The final 7% is split between precious metals and livestock. The GSCI is designed to reflect reality without concern for investability.

The question is do you want exposure to commodities in proportion to their economic impact? If so, then like the global economy, you will be mostly concerned with crude oil and not concerned with other things. The GSCI index is diverse (24 components) because global commodities markets are diverse. But it is fantastically concentrated in oil because the global economy is concentrated on oil.

Compared to the GCSI, the Deutsche Bank Liquid Commodity Index is minimalist. The benchmark for (DBC) is made up of 35% crude oil, 20% heating oil, 12.5% aluminum, 11.25% corn, 11.25% wheat and 10% gold.

Recently Deutsche Bank has implemented an algorithm that attempts to roll the futures contracts in the index so as to minimize the effects of contango and take advantage of backwardation. Until the new DBC index is established, we can't tell if the advantages of Deutsche Bank's roll yield management will outweigh the difference in cost (1.30% vs 0.75%) and the effects of index performance.


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