This month, United States Commodity Funds, which is behind the $1.1 billion United States Oil fund (USO), launched the United States Copper Index Fund (CPER), the first copper-based, exchange-traded fund in the U.S. While the fund is the first ETF to target the copper market, it does join two copper-based, exchange-traded notes: the iPath Pure Beta Copper ETN (CUPM) and iPath Dow Jones-UBS Copper Total Return ETN (JJC). Hard Assets Investor Managing Editor Drew Voros caught up with John Hyland, chief investment officer for United States Commodity Funds, to discuss the launch and issues surrounding copper as a commodity.
Hard Assets Investor: Why did you think a copper ETF was necessary?
John Hyland: For the last four or five years, I’ve been making the point to people at various ETF and commodity conferences that eventually every major, actively traded commodity or a commodity at an active futures market was eventually going to have at least one ETF that essentially equitizes the futures contract.
When we launched USO [the United States Oil Fund] in 2006, I would tell people that there are 40 to 45 commodities that trade around the world with reasonable amounts of activity in the futures world. But there are another 40 or 50 that are obscure. Of that, there's two dozen or so that trade a decent amount and trade in the U.S. or London. And copper is the most important and most actively traded, really, of the industrials. And, because its use is so ubiquitous, many people feel that it’s a very good proxy as a commodity for what’s going on in the real economy — that if the real economy, on a global basis, is growing, then demand for copper grows, and vice versa.
On that basis alone, it was worth a look. It hadn’t been done yet as an ETF in the United States. It was an opportunity for our firm to actually do it without being the third or fourth to market. If you look at longer-term trend lines for commodities in general — say over the last 30 years — just looking at industrial metals, copper tends to really be a strong performer.
Because of the way copper resonates with the real economy and because of the fact that it tends to be supply constrained are good reasons for a copper ETF.
HAI: How do the underlying contracts work?
Hyland: Copper trades in two markets. It trades in New York on the COMEX and on the LME in London. We elected for COMEX as the basis, although we quite easily could have chosen the LME.
As for the methodology, the fund is based on another index created by SummerHaven Index Management that minimizes contango. Unlike like a first-generation index approach that says, “I’m always going to be in copper. And I’m always just going to own the first- or second-month contract,” this index was designed around the notion that “I’m always going to be in copper if the market is in backwardation.”
When copper is in backwardation, you have low inventory. What the index would do is take 50 percent of the index and put it in whichever contract in the front four months is most backwardated. It doesn’t have to be month one. It could be month two or three. The other half is put into the second-most backwardated of the front four. You're basically going to put money at the front of the curve, because you're in backwardation where the front end of the curve tends to do better.
If, on the other hand, the commodity is in contango, you don’t want to have all of the weighting in the front month. Because, in fact, research would show that you get better performance by contracts further away from the front month. That would tend to be less negatively impacted by the drag of contango. In that case, the index says, “OK, we’re going to keep 25 percent of the money in the most backwardated or least contangoed, front-month contract. We’re going to put 25 percent of the weight in the second-most backwardated or least contangoed of the front four. And we’re going to take 50 percent of the weight, and we’re going to put it back into December 2012.”
Why put it back? In a contango environment, the further back you are, the better you typically do. December always has a lot of open interest in volume, even if contracts on either side of it don’t. When the index was being built by the folks at SummerHaven, they were aware that you can do things on paper that look like a great idea. You can go to any contract in the front 12 months or 18 months that looks the best. But, if it’s a very, very thinly traded month, it looks great on paper, but it doesn’t actually work if you try to run a portfolio off it. You discover that you're the only person who ever wants to buy or sell that month.
SummerHaven built this index with the thought that it’s a great idea to say we’re going to weight the index back. But you have to weight it to a month where you actually believe it’s going to be practical to go buy large numbers of contracts or sell large numbers of contracts. So that’s how they came up with moving it back and forth.
HAI: Let’s talk a little bit about copper itself. Can copper be a hedge against inflation?
Hyland: Commodities in general, and copper in particular, are strong hedges against inflation. But you can't really look at inflation over just three months or six months. If you think inflation is going to be higher, you have to look at it over five years. What are the things you can do that actually will probably help you hedge that? Commodities, as a general case, clearly fall into that.
HAI: When it comes to copper, does it pretty much all begin and end with China?
Hyland: That’s the biggie. A month or two ago we filed for a fund that will consist of an Asian commodity basket. In it, we included some data showing the global amount of production of a basket of different commodities, not just China. We were using China, Japan and India, which, combined, are 85 percent of the GDP of Asia and 75 percent of the population. So basically, the three account for what matters to Asia.
Our statistics showed that the three countries produce less than 10 percent of the global production of copper, but about 44 percent of the global consumption comes out of those countries. And that is, at present, mostly China. The biggest use of copper, of course, is electrical. It’s still obviously used in a lot of manufacturing. You use it for cars. You use it for a lot of things. But the single, biggest component is electrical. China is undergoing a situation now, maybe somewhat analogous to the United States in the 1930s, with the TVA, or post-World War II. But they're wiring up the country.
